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Federal Register, Volume 79 Issue 192 (Friday, October 3, 2014)
[Federal Register Volume 79, Number 192 (Friday, October 3, 2014)]
[Proposed Rules]
[Pages 59897-59936]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2014-22962]
[[Page 59897]]
Vol. 79
Friday,
No. 192
October 3, 2014
Part II
Commodity Futures Trading Commission
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17 CFR Parts 23 and 140
Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap
Participants; Proposed Rule
Federal Register / Vol. 79 , No. 192 / Friday, October 3, 2014 /
Proposed Rules
[[Page 59898]]
———————————————————————–
COMMODITY FUTURES TRADING COMMISSION
17 CFR Parts 23 and 140
RIN 3038-AC97
Margin Requirements for Uncleared Swaps for Swap Dealers and
Major Swap Participants
AGENCY: Commodity Futures Trading Commission.
ACTION: Proposed rule; advance notice of proposed rulemaking.
———————————————————————–
SUMMARY: The Commodity Futures Trading Commission (“Commission” or
“CFTC”) is proposing regulations to implement section 4s(e) of the
Commodity Exchange Act (“CEA”), as added by section 731 of the Dodd-
Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank
Act”). This provision requires the Commission to adopt initial and
variation margin requirements for certain swap dealers (“SDs”) and
major swap participants (“MSPs”). The proposed rules would establish
initial and variation margin requirements for SDs and MSPs but would
not require SDs and MSPs to collect margin from non-financial end
users. In this release, the Commission is also issuing an Advance
Notice of Proposed Rulemaking requesting public comment on the cross-
border application of such margin requirements. The Commission is not
proposing rules on this topic at this time. It is seeking public
comment on several potential alternative approaches.
DATES: Comments must be received on or before December 2, 2014.
ADDRESSES: You may submit comments, identified by RIN 3038-AC97 and
Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap
Participants, by any of the following methods:
Agency Web site, via its Comments Online process at http://comments.cftc.gov. Follow the instructions for submitting comments
through the Web site.
Mail: Send to Christopher Kirkpatrick, Secretary of the
Commission, Commodity Futures Trading Commission, Three Lafayette
Centre, 1155 21st Street NW., Washington, DC 20581.
Hand Delivery/Courier: Same as Mail, above.
Federal eRulemaking Portal: http://www.regulations.gov.
Follow the instructions for submitting comments.
Please submit your comments using only one of these methods.
All comments must be submitted in English, or if not, accompanied
by an English translation. Comments will be posted as received to
http://www.cftc.gov. You should submit only information that you wish
to make available publicly. If you wish the Commission to consider
information that may be exempt from disclosure under the Freedom of
Information Act, a petition for confidential treatment of the exempt
information may be submitted according to the established procedures in
Sec. 145.9 of the Commission’s regulations, 17 CFR 145.9.
The Commission reserves the right, but shall have no obligation, to
review, pre-screen, filter, redact, refuse or remove any or all of your
submission from www.cftc.gov that it may deem to be inappropriate for
publication, such as obscene language. All submissions that have been
redacted, or removed that contain comments on the merits of the
rulemaking will be retained in the public comment file and will be
considered as required under the Administrative Procedure Act and other
applicable laws, and may be accessible under the Freedom of Information
Act.
FOR FURTHER INFORMATION CONTACT: John C. Lawton, Deputy Director,
Division of Clearing and Risk, 202-418-5480, [email protected]; Thomas
J. Smith, Deputy Director, Division of Swap Dealer and Intermediary
Oversight, 202-418-5495, [email protected]; Rafael Martinez, Financial
Risk Analyst, Division of Swap Dealer and Intermediary Oversight, 202-
418-5462, [email protected]; Francis Kuo, Attorney, Division of Swap
Dealer and Intermediary Oversight, 202-418-5695, [email protected]; or
Stephen A. Kane, Research Economist, Office of Chief Economist, 202-
418-5911, [email protected]; Commodity Futures Trading Commission, 1155
21st Street NW., Washington DC 20581.
SUPPLEMENTARY INFORMATION:
I. Background
A. Statutory Authority
On July 21, 2010, President Obama signed the Dodd-Frank Act.1
Title VII of the Dodd-Frank Act amended the CEA 2 to establish a
comprehensive regulatory framework designed to reduce risk, to increase
transparency, and to promote market integrity within the financial
system by, among other things: (1) Providing for the registration and
regulation of SDs and MSPs; (2) imposing clearing and trade execution
requirements on standardized derivative products; (3) creating
recordkeeping and real-time reporting regimes; and (4) enhancing the
Commission’s rulemaking and enforcement authorities with respect to all
registered entities and intermediaries subject to the Commission’s
oversight.
—————————————————————————
1 See Dodd-Frank Wall Street Reform and Consumer Protection
Act, Public Law 111-203, 124 Stat. 1376 (2010).
2 7 U.S.C. 1 et seq.
—————————————————————————
Section 731 of the Dodd-Frank Act added a new section 4s to the CEA
setting forth various requirements for SDs and MSPs. Section 4s(e)
mandates the adoption of rules establishing margin requirements for SDs
and MSPs.3 Each SD and MSP for which there is a Prudential Regulator,
as defined below, must meet margin requirements established by the
applicable Prudential Regulator, and each SD and MSP for which there is
no Prudential Regulator must comply with the Commission’s regulations
governing margin.
—————————————————————————
3 Section 4s(e) also directs the Commission to adopt capital
requirements for SDs and MSPs. The Commission proposed capital rules
in 2011. Capital Requirements for Swap Dealers and Major Swap
Participants, 76 FR 27802 (May 12, 2011). The Commission will
address capital requirements in a separate release.
—————————————————————————
The term Prudential Regulator is defined in section 1a(39) of the
CEA, as amended by Section 721 of the Dodd-Frank Act. This definition
includes the Federal Reserve Board (“FRB”); the Office of the
Comptroller of the Currency (“OCC”); the Federal Deposit Insurance
Corporation (“FDIC”); the Farm Credit Administration; and the Federal
Housing Finance Agency.
The definition specifies the entities for which these agencies act
as Prudential Regulators. These consist generally of federally insured
deposit institutions, farm credit banks, federal home loan banks, the
Federal Home Loan Mortgage Corporation, and the Federal National
Mortgage Association. The FRB is the Prudential Regulator under section
4s not only for certain banks, but also for bank holding companies,
certain foreign banks treated as bank holding companies, and certain
subsidiaries of these bank holding companies and foreign banks. The FRB
is not, however, the Prudential Regulator for nonbank subsidiaries of
bank holding companies, some of which are required to be registered
with the Commission as SDs or MSPs. In general, therefore, the
Commission is required to establish margin requirements for all
registered SDs and MSPs that are not subject to a Prudential Regulator.
These include, among others, nonbank subsidiaries of bank holding
companies, as well as certain foreign SDs and MSPs.
Specifically, section 4s(e)(1)(B) of the CEA provides that each
registered SD
[[Page 59899]]
and MSP for which there is not a Prudential Regulator shall meet such
minimum capital requirements and minimum initial margin and variation
margin requirements as the Commission shall by rule or regulation
prescribe.
Section 4s(e)(2)(B) provides that the Commission shall adopt rules
for SDs and MSPs, with respect to their activities as an SD or an MSP,
for which there is not a Prudential Regulator imposing (i) capital
requirements and (ii) both initial and variation margin requirements on
all swaps that are not cleared by a registered derivatives clearing
organization (“DCO”).
Section 4s(e)(3)(A) provides that to offset the greater risk to the
SD or MSP and the financial system arising from the use of swaps that
are not cleared, the requirements imposed under section 4s(e)(2) shall
(i) help ensure the safety and soundness of the SD or MSP and (ii) be
appropriate for the risk associated with the non-cleared swaps.
Section 4s(e)(3)(C) provides, in pertinent part, that in
prescribing margin requirements the Prudential Regulator and the
Commission shall permit the use of noncash collateral the Prudential
Regulator or the Commission determines to be consistent with (i)
preserving the financial integrity of markets trading swaps and (ii)
preserving the stability of the United States financial system.
Section 4s(e)(3)(D)(i) provides that the Prudential Regulators, the
Commission, and the Securities and Exchange Commission (“SEC”) shall
periodically (but not less frequently than annually) consult on minimum
capital requirements and minimum initial and variation margin
requirements.
Section 4s(e)(3)(D)(ii) provides that the Prudential Regulators,
Commission and SEC shall, to the maximum extent practicable, establish
and maintain comparable minimum capital and minimum initial and
variation margin requirements, including the use of noncash collateral,
for SDs and MSPs.
B. Previous Proposal
Following extensive consultation and coordination with the
Prudential Regulators, the Commission published proposed rules for
public comment in 2011.4 The Prudential Regulators published
substantially similar rules two weeks later.5
—————————————————————————
4 Margin Requirements for Uncleared Swaps for Swap Dealers and
Major Swap Participants, 76 FR 23732 (April 28, 2011).
5 Margin and Capital Requirements for Covered Swap Entities,
76 FR 27564 (May 11, 2011).
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The Commission received 102 comment letters. The Prudential
Regulators received a comparable number. The commenters included
financial services industry associations, agricultural industry
associations, energy industry associations, insurance industry
associations, banks, brokerage firms, investment managers, insurance
companies, pension funds, commercial end users, law firms, public
interest organizations, and other members of the public. The commenters
addressed numerous topics including applicability of the rules to
certain products, applicability to certain market participants, margin
calculation methodologies, two-way vs. one-way margin, margin
thresholds, permissible collateral, use of independent custodians,
rehypothecation of collateral, and harmonization with other regulators.
The Commission has taken the comments it received into
consideration in developing the further proposal contained herein. This
proposal differs in a number of material ways from the previous
proposal 6 and the Commission has determined that it is appropriate
to issue a new request for comment. The Prudential Regulators have also
decided to issue a new request for comment. The public is invited to
comment on any aspect of the current proposal.
—————————————————————————
6 These include, among others, the definition of financial end
user, the definition of material swaps exposure, the requirement for
two-way margin between SDs and financial end users, and the list of
eligible collateral for initial margin.
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C. International Standards
While the comments on the 2011 proposal were being reviewed,
regulatory authorities around the world determined that global
harmonization of margin standards was an important goal. The CFTC and
the Prudential Regulators decided to hold their rulemakings in abeyance
pending completion of the international efforts.
In October 2011, the Basel Committee on Banking Supervision
(“BCBS”) and the International Organization of Securities Commissions
(“IOSCO”), in consultation with the Committee on Payment and
Settlement Systems (“CPSS”) and the Committee on Global Financial
Systems (“CGFS”), formed a working group to develop international
standards for margin requirements for uncleared swaps. Representatives
of more than 20 regulatory authorities participated. From the United
States, the CFTC, the FDIC, the FRB, the OCC, the Federal Reserve Bank
of New York, and the SEC were represented.
In July 2012, the working group published a proposal for public
comment.7 In addition, the group conducted a Quantitative Impact
Study (“QIS”) to assess the potential liquidity and other
quantitative impacts associated with margin requirements.8
—————————————————————————
7 BCBS/IOSCO, Consultative Document, Margin requirements for
non-centrally cleared derivatives (July 2012).
8 BCBS/IOSCO, Quantitative Impact Study, Margin requirements
for non-centrally cleared derivatives (November 2012).
—————————————————————————
After consideration of the comments on the proposal and the results
of the QIS, the group published a near-final proposal in February 2013
and requested comment on several specific issues.9 The group
considered the additional comments in finalizing the recommendations
set out in the report.
—————————————————————————
9 BCBS/IOSCO, Consultative Document, Margin requirements for
non-centrally cleared derivatives (February 2013).
—————————————————————————
The final report was issued in September 2013.10 This report (the
“2013 international framework”) articulates eight key principles for
non-cleared derivatives margin rules, which are described below. These
principles represent the minimum standards approved by BCBS and IOSCO
and recommended to the regulatory authorities in member jurisdictions
of these organizations.
—————————————————————————
10 BCBS/IOSCO, Margin requirements for non-centrally cleared
derivatives (September 2013) (“BCBS/IOSCO Report”).
—————————————————————————
1. Appropriate Margining Practices Should be in Place With Respect to
all Non-Cleared Derivative Transactions
The 2013 international framework recommends that appropriate
margining practices be in place with respect to all derivative
transactions that are not cleared by central counterparties (“CCPs”).
The 2013 international framework does not include a margin requirement
for physically settled foreign exchange (“FX”) forwards and swaps.
The framework also would not apply initial margin requirements to the
fixed physically-settled FX component of cross-currency swaps.
2. Financial Firms and Systemically Important Nonfinancial Entities
(Covered Entities) Must Exchange Initial and Variation Margin
The 2013 international framework recommends bilateral exchange of
initial and variation margin for non-cleared derivatives between
covered entities. The precise definition of “covered entities” is to
be determined by each national regulator, but in general should include
financial firms and systemically important non-financial entities.
Sovereigns, central banks, certain multilateral development banks, the
Bank for International
[[Page 59900]]
Settlements (BIS), and non-systemic, non-financial firms are not
included as covered entities.
Under the 2013 international framework, all covered entities that
engage in non-cleared derivatives should exchange, on a bilateral
basis, the full amount of variation margin with a zero threshold on a
regular basis (e.g., daily). All covered entities are also expected to
exchange, on a bilateral basis, initial margin with a threshold not to
exceed [euro]50 million. The threshold applies on a consolidated group,
rather than legal entity, basis. In addition, and in light of the
permitted initial margin threshold, the 2013 international framework
recommends that entities with a level of non-cleared derivative
activity of [euro]8 billion notional or more would be subject to
initial margin requirements.
3. The Methodologies for Calculating Initial and Variation Margin
Should (i) Be Consistent Across Covered Entities, and (ii) Ensure That
All Counterparty Risk Exposures Are Covered With a High Degree of
Confidence
The 2013 international framework states that the potential future
exposure of a non-cleared derivative should reflect an estimate of an
increase in the value of the instrument that is consistent with a one-
tailed 99% confidence level over a 10-day horizon (or longer, if
variation margin is not collected on a daily basis), based on
historical data that incorporates a period of significant financial
stress.
The 2013 international framework permits the amount of initial
margin to be calculated by reference to internal models approved by the
relevant national regulator or a standardized margin schedule, but
covered entities should not “cherry pick” between the two calculation
methods. Models may allow for conceptually sound and empirically
demonstrable portfolio risk offsets where there is an enforceable
netting agreement in effect. However, portfolio risk offsets may only
be recognized within, and not across, certain well-defined asset
classes: credit, equity, interest rates and foreign exchange, and
commodities. A covered entity using the standardized margin schedule
may adjust the gross initial margin amount (notional exposure
multiplied by the relevant percentage in the table) by a “net-to-gross
ratio,” which is also used in the bank counterparty credit risk
capital rules to reflect a degree of netting of derivative positions
that are subject to an enforceable netting agreement.
4. To Ensure That Assets Collected as Collateral Can Be Liquidated in a
Reasonable Amount of Time To Generate Proceeds That Could Sufficiently
Protect Covered Entities From Losses in the Event of a Counterparty
Default, These Assets Should Be Highly Liquid and Should, After
Accounting for an Appropriate Haircut, be Able To Hold Their Value in a
Time of Financial Stress
The 2013 international framework recommends that national
supervisors develop a definitive list of eligible collateral assets.
The 2013 international framework includes examples of permissible
collateral types, provides a schedule of standardized haircuts, and
indicates that model-based haircuts may be appropriate. In the event
that a dispute arises over the value of eligible collateral, the 2013
international framework provides that both parties should make all
necessary and appropriate efforts, including timely initiation of
dispute resolution protocols, to resolve the dispute and exchange any
required margin in a timely fashion.
5. Initial Margin Should be Exchanged on a Gross Basis and Held in Such
a Way as to Ensure That (i) the Margin Collected Is Immediately
Available to the Collecting Party in the Event of the Counterparty’s
Default, and (ii) the Collected Margin Is Subject to Arrangements That
Fully Protect the Posting Party
The 2013 international framework provides that collateral collected
as initial margin from a “customer” (defined as a “buy-side
financial firm”) should be segregated from the initial margin
collector’s proprietary assets. The initial margin collector also
should give the customer the option to individually segregate its
initial margin from other customers’ margin. In very specific
circumstances, the initial margin collector may use margin provided by
the customer to hedge the risks associated with the customer’s
positions with a third party. To the extent that the customer consents
to rehypothecation, it should be permitted only where applicable
insolvency law gives the customer protection from risk of loss of
initial margin in instances where either or both of the initial margin
collector and the third party become insolvent. Where a customer has
consented to rehypothecation and adequate legal safeguards are in
place, the margin collector and the third party to which customer
collateral is rehypothecated should comply with additional restrictions
detailed in the 2013 international framework, including a prohibition
on any further rehypothecation of the customer’s collateral by the
third party.
6. Requirements for Transactions Between Affiliates Are Left to the
National Supervisors
The 2013 international framework recommends that national
supervisors establish margin requirements for transactions between
affiliates as appropriate in a manner consistent with each
jurisdiction’s legal and regulatory framework.
7. Requirements for Margining Non-Cleared Derivatives Should Be
Consistent and Non-Duplicative Across Jurisdictions
Under the 2013 international framework, home-country supervisors
may allow a covered entity to comply with a host-country’s margin
regime if the host-country margin regime is consistent with the 2013
international framework. A branch may be subject to the margin
requirements of either the headquarters’ jurisdiction or the host
country.
8. Margin Requirements Should Be Phased in Over an Appropriate Period
of Time
The 2013 international framework phases in margin requirements
between December 2015 and December 2019. Covered entities should begin
exchanging variation margin by December 1, 2015. The date on which a
covered entity should begin to exchange initial margin with a
counterparty depends on the notional amount of non-cleared derivatives
(including physically settled FX forwards and swaps) entered into both
by its consolidated corporate group and by the counterparty’s
consolidated corporate group.
Currency denomination. The 2013 international framework recommends
specific quantitative levels for several requirements such as the level
of notional derivative exposure that results in an entity being subject
to the margin requirements ([euro]8 billion), permitted initial margin
thresholds ([euro]50 million), and minimum transfer amounts
([euro]500,000). In the 2013 international framework, all such amounts
are denominated in Euros. In this proposal all such amounts are
denominated in U.S. dollars. The Commission is aware that, over time,
amounts that are denominated in different currencies in different
jurisdictions may fluctuate relative to one another due to changes in
exchange rates.
[[Page 59901]]
The Commission seeks comment on whether and how fluctuations
resulting from exchange rate movements should be addressed. In
particular, should these amounts be expressed in terms of a single
currency in all jurisdictions to prevent such fluctuations? Should the
amounts be adjusted over time if and when exchange rate movements
necessitate realignment? Are there other approaches to deal with
fluctuations resulting from significant exchange rate movements? Are
there other issues that should be considered in connection to the
effects of fluctuating exchange rates?
II. Proposed Margin Regulations
A. Introduction
During the financial crisis of 2008-2009, DCOs met all their
obligations without any financial support from the government. By
contrast, significant sums were expended by governmental entities as
the result of losses incurred in connection with uncleared swaps. For
example, a unit of American International Group (“AIG”) entered into
many credit default swaps and did not post initial margin or regularly
pay variation margin on these positions.11 AIG was unable to meet its
obligations and the Federal Reserve and the Department of the Treasury
expended large sums of money to meet these obligations.12
—————————————————————————
11 See The Financial Crisis Inquiry Commission, The Financial
Crisis Inquiry Report: Final Report of the National Commission on
the Causes of the Financial and Economic Crisis in the United States
(Official Government Edition) at 265-268 (2011), available at http://fcic-static.law.stanford.edu/cdn_media/fcic-reports/fcic_final_report_full.pdf.
12 Id. at 344-352, 350. See also United States Department of
the Treasury, Office of Financial Stability, Troubled Asset Relief
Program, Four Year Retrospective: An Update on the Wind Down of
TARP, pp. 3, 18-19. Treasury and the Federal Reserve committed $182
billion to stabilize AIG. Ultimately all of this was recovered plus
a return of $22.7 billion.
—————————————————————————
A key reason for this difference in the performance of cleared and
uncleared swaps is that DCOs use variation margin and initial margin as
the centerpiece of their risk management programs while these tools
often were not universally used in connection with uncleared swaps.
Consequently, in designing the proposed margin rules for uncleared
swaps, the Commission has built upon the sound practices for risk
management employed by central counterparties for decades.
Variation margin serves as a mechanism for periodically recognizing
changes in the value of open positions and reducing unrealized losses
to zero. Open positions are marked to their current market value each
day and funds are transferred between the parties to reflect any change
in value since the previous time the positions were marked. This
process prevents losses from accumulating over time and thereby reduces
both the chance of default and the size of any default should one
occur.
Initial margin serves as a performance bond against potential
future losses. If a party fails to meet its obligation to pay variation
margin, resulting in a default, the other party may use initial margin
to cover some or all of any loss. Because the payment of variation
margin prevents losses from compounding over an extended period of
time, initial margin only needs to cover any additional losses that
might accrue between the previous time that variation margin was paid
and the time that the position is liquidated.
Well-designed margin systems protect both parties to a trade as
well as the overall financial system. They serve both as a check on
risk-taking that might exceed a party’s financial capacity and as a
resource that can limit losses when there is a failure by a party to
meet its obligations.
The statutory provisions cited above reflect Congressional
recognition that (i) margin is an essential risk-management tool and
(ii) uncleared swaps pose greater risks than cleared swaps. As
discussed further below, many commenters expressed concern that the
imposition of margin requirements on uncleared swaps will be very
costly for SDs and MSPs.13 However, margin has been, and will
continue to be, required for all cleared products. Given the
Congressional reference to the “greater risk” of uncleared swaps and
the requirement that margin for such swaps “be appropriate for the
risk,” the Commission believes that establishing margin requirements
for uncleared swaps that are at least as stringent as those for cleared
swaps is necessary to fulfill the statutory mandate. Within these
statutory bounds the Commission has endeavored to limit costs
appropriately, as detailed further below.
—————————————————————————
13 For purposes of this proposal, the term “SD” means any
swap dealer registered with the Commission. Similarly, the term
“MSP” means any major swap participant registered with the
Commission.
—————————————————————————
The discussion below addresses: (i) The products covered by the
proposed rules; (ii) the market participants covered by the proposed
rules; (iii); the nature and timing of the margin obligations; (iv) the
methods of calculating initial margin; (v) the methods of calculating
variation margin; (vi) permissible forms of margin; (vii) custodial
arrangements; (viii) documentation requirements; (ix) the
implementation schedule; and (x) advance notice of proposed rulemaking
on the cross-border application of the rules.
In developing the proposed rules, the Commission staff worked
closely with the staff of the Prudential Regulators.14 In most
respects, the proposed rules would establish a similar framework for
margin requirements as the Prudential Regulators’ proposal. Key
differences are noted in the discussion below.
—————————————————————————
14 As required by section 4s of the CEA, the Commission staff
also has consulted with the SEC staff.
—————————————————————————
The proposed rules are consistent with the 2013 international
framework. In some instances, as contemplated in the framework, the
proposed rules provide more detail than the framework. In a few other
instances, the proposed rules are stricter than the framework. Any such
variations from the framework are noted in the discussion below.
B. Products
As noted above, section 4s(e)(2)(B)(ii) of the CEA directs the
Commission to establish both initial and variation margin requirements
for SDs and MSPs “on all swaps that are not cleared.” The scope
provision of the proposed rules 15 states that the proposal would
cover swaps that are uncleared swaps 16 and that are executed after
the applicable compliance date.17
—————————————————————————
15 Proposed Regulation Sec. 23.150.
16 The term uncleared swap is defined in proposed Regulation
Sec. 23.151.
17 A schedule of compliance dates is set forth in proposed
Regulation Sec. 23.160.
—————————————————————————
The term “cleared swap” is defined in section 1a(7) of the CEA to
include any swap that is cleared by a DCO registered with the
Commission. The Commission notes, however, that SDs and MSPs also clear
swaps through foreign clearing organizations that are not registered
with the Commission. The Commission believes that a clearing
organization that is not a registered DCO must meet certain basic
standards in order to avoid creating a mechanism for evasion of the
uncleared margin requirements. Accordingly, the Commission is proposing
to include in the definition of cleared swaps certain swaps that have
been accepted for clearing by an entity that has received a no-action
letter from the Commission staff or exemptive relief from the
Commission permitting it to clear such swaps for U.S. persons without
being registered as a DCO.18
—————————————————————————
18 See CFTC Ltr. No. 14-107 (August 18, 2014) (granting no-
action relief to Clearing Corporation of India Ltd.); CFTC Ltr. No.
14-87 (June 26, 2014) (granting no-action relief to Korea Exchange,
Inc.); CFTC Ltr. No. 14-68 (May 7, 2014) (granting no-action relief
to OTC Clearing Hong Kong Limited and certain of its clearing
members); CFTC Ltr. No. 14-27 (Mar. 20, 2014) (extending previous
grant of no-action relief to Eurex Clearing AG and certain of its
clearing members); CFTC Ltr. No. 14-07 (Feb. 6, 2014) (granting no-
action relief to ASX Clear (Futures) Pty Limited); and CFTC Ltr. No.
13-73 (Dec. 19, 2013) (extending previous grant of no-action relief
to Japan Securities Clearing Corporation and certain of its clearing
members).
—————————————————————————
[[Page 59902]]
The Commission requests comment on whether it is appropriate to
exclude swaps that are cleared by an entity that is not a registered
DCO. If so, the Commission further requests comment on whether the
proposed rule captures the proper clearing organizations. For example,
should the Commission require that the clearing organizations be
qualifying central counterparties (“QCCPs”) 19 or be subject to
regulation and supervision that is consistent with the CPSS-IOSCO
Principles for Financial Market Infrastructures (“PFMIs”)?
—————————————————————————
19 A QCCP is a clearing organization that meets the standards
to be designated as such set forth by the Basel Committee for
Banking Supervision in the report “Capital requirements for bank
exposures to central counterparties” (April 2014).
—————————————————————————
Because the pricing of swaps reflects the credit arrangements under
which they were executed, it could be unfair to the parties and
disruptive to the markets to require that the rules apply to positions
executed before the applicable compliance dates. The rules, however,
would permit SDs and MSPs voluntarily to include swaps executed before
the applicable compliance date in portfolios margined pursuant to the
proposed rules.20 Many market participants might do so to take
advantage of netting effects across transactions.
—————————————————————————
20 See proposed Regulation Sec. 23.154(b)(2) for initial
margin and proposed Regulation Sec. 23.153(c) for variation margin.
—————————————————————————
As a result of the determination by the Secretary of the Treasury
to exempt foreign exchange swaps and foreign exchange forwards from the
definition of swap,21 the following transactions would not be subject
to the requirements: (i) Foreign exchange swaps; (ii) foreign exchange
forwards; and (iii) the fixed, physically settled foreign exchange
transactions associated with the exchange of principal in cross-
currency swaps.
—————————————————————————
21 Determination of Foreign Exchange Swaps and Foreign
Exchange Forwards Under the Commodity Exchange Act, 77 FR 69694
(Nov. 20, 2012).
—————————————————————————
In a cross-currency swap, the parties exchange principal and
interest rate payments in one currency for principal and interest rate
payments in another currency. The exchange of principal occurs upon the
inception of the swap, with a reversal of the exchange of principal at
a later date that is agreed upon at the inception of the swap. The
foreign exchange transactions associated with the fixed exchange of
principal in a cross-currency swap are closely related to the exchange
of principal that occurs in the context of a foreign exchange forward
or swap. Accordingly, the Commission is proposing to treat that portion
of a cross-currency swap that is a fixed exchange of principal in a
manner that is consistent with the treatment of foreign exchange
forwards and swaps. This treatment of cross-currency swaps is limited
to cross-currency swaps and does not extend to any other swaps such as
non-deliverable currency forwards.
The Commission requests comment on the proposed treatment of
products. In particular, commenters are invited to discuss the costs
and benefits of the proposed approach. Commenters are urged to quantify
the costs and benefits, if practicable. Commenters also may suggest
alternatives to the proposed approach where the commenters believe that
the alternatives would be appropriate under the CEA.
C. Market Participants
1. SDs and MSPs
As noted above, section 4s(e)(2)(B) of the CEA directs the
Commission to impose margin requirements on SDs and MSPs for which
there is no Prudential Regulator (“covered swap entities” or
“CSEs”).22 This provision further states that the requirement shall
apply to “all swaps that are not cleared.” Section 4s(e)(3)(A)(2)
states that the requirements must be “appropriate to the risks
associated with” the swaps.
—————————————————————————
22 This term is defined in proposed Regulation Sec. 23.151.
—————————————————————————
Because different types of counterparties can pose different levels
of risk, the Commission’s proposed requirements would differ depending
on the category of counterparty. The proposed rules would establish
three categories of counterparty: (i) SDs and MSPs, (ii) financial end
users,23 and (iii) non-financial end users.24 As discussed below,
the nature of an SD/MSP’s obligations under the rules would differ
depending on whether the counterparty was a covered counterparty or a
non-financial end user.
—————————————————————————
23 This term is defined in proposed Regulation Sec. 23.151.
24 This term is defined in proposed Regulation Sec. 23.151 to
include entities that are not SDs, MSPs, or financial entities.
—————————————————————————
2. Financial End Users
a. Definition
Financial end users would include any entity that (i) is specified
in the definition, and (ii) is not an SD or MSP. The definition lists
numerous entities whose business is financial in nature. The proposed
rule also would permit the Commission to designate additional entities
as financial end users if it identified additional entities whose
activities and risk profile would warrant inclusion. As contemplated by
the 2013 international framework, the CFTC proposal, which is the same
as the Prudential Regulator’s proposal, contains greater detail in
defining financial end users than the international standards.25
—————————————————————————
25 “The precise definition of financial firms, non-financial
firms, and systemically important non-financial firms will be
determined by appropriate national regulation.” See BCBS/IOSCO
Report at 9.
—————————————————————————
In developing the definition, the Commission and the Prudential
Regulators sought to provide clarity about whether particular
counterparties would be subject to the margin requirements of the
proposed rule. The definition is an attempt to strike a balance between
the need to capture all financial counterparties that pose significant
risk to the financial system and the danger of being overly inclusive.
The Commission believes that financial firms generally present a
higher level of risk than other types of counterparties because the
profitability and viability of financial firms is more tightly linked
to the health of the financial system than other types of
counterparties. Because financial counterparties are more likely to
default during a period of financial stress, they pose greater systemic
risk and risk to the safety and soundness of the CSE.
The list of financial entities is based to a significant extent on
Federal statutes that impose registration or chartering requirements on
entities that engage in specified financial activities. Such activities
include deposit taking and lending, securities and swaps dealing,
investment advisory activities, and asset management.
Because Federal law largely looks to the States for the regulation
of the business of insurance, the proposed definition broadly includes
entities organized as insurance companies or supervised as such by a
State insurance regulator. This element of the proposed definition
would extend to reinsurance and monoline insurance firms, as well as
insurance firms supervised by a foreign insurance regulator.
The proposal also would cover a broad variety and number of nonbank
lending and retail payment firms that operate in the market. To this
end, the proposal would include State-licensed or registered credit or
lending entities
[[Page 59903]]
and money services businesses, under proposed regulatory language
incorporating an inclusive list of the types of firms subject to State
law.26 However, the Commission recognizes that the licensing of
nonbank lenders in some states extends to commercial firms that provide
credit to the firm’s customers in the ordinary course of business.
Accordingly, the Commission is proposing to exclude an entity
registered or licensed solely because it finances the entity’s direct
sales of goods or services to customers. The Commission requests
comment on whether this aspect of the proposed rule adequately
maintains a distinction between financial end users and commercial end
users.
—————————————————————————
26 The Commission expects that financial cooperatives that
provide financial services to their members, such as lending to
their members and entering into swaps in connection with those
loans, would be treated as financial end users, pursuant to this
aspect of the proposed rule’s coverage of credit or lending
entities.
—————————————————————————
In addition, real estate investment companies would be financial
end users, as they are entities that would be investment companies
under section 3 of the Investment Company Act but for section
3(c)(5)(C). Furthermore, other securitization vehicles would be
financial end users in cases where those vehicles are entities that are
deemed not to be investment companies under section 3 of the Investment
Company Act pursuant to Rule 3a-7. The Commission also notes that the
category of investment companies registered with the SEC under the
Investment Company Act would include registered investment companies as
well as business development companies.
Under the proposed rule, those cooperatives that are financial
institutions, such as credit unions, Farm Credit System banks and
associations, and the National Rural Utilities Cooperative Finance
Corporation would be financial end users because their sole business is
lending and providing other financial services to their members,
including engaging in swaps in connection with such loans.27
Cooperatives that are financial end users may qualify for an exemption
from clearing,28 and therefore, they may enter into non-cleared swaps
with covered swap entities that are subject to the proposed rule.
—————————————————————————
27 Under the proposed rule, the financing subsidiaries or
affiliates of producer or consumer cooperatives would be non-
financial end users.
28 Section 2(h)(7)(c)(ii) of the CEA and section 3C(g)(4) of
the Securities Exchange Act of 1934 authorize the CFTC and the SEC,
respectively, to exempt small depository institutions, small Farm
Credit System institutions, and small credit unions with total
assets of $10 billion or less from the mandatory clearing
requirements for swaps and security-based swaps. Additionally, the
CFTC, pursuant to its authority under section 2(h)(1)(A) of the CEA,
enacted 17 CFR 50.51, which allows cooperative financial entities,
including those with total assets in excess of $10 billion, to elect
an exemption from mandatory clearing of swaps that: (1) They enter
into in connection with originating loans for their members; or (2)
hedge or mitigate commercial risk related to loans or swaps with
their members.
—————————————————————————
The Commission remains concerned, however, that one or more types
of financial entities might escape classification under the specific
Federal or State regulatory regimes included in the proposed definition
of a financial end user. Accordingly, the definition includes two
additional prongs. First, the definition would cover an entity that is,
or holds itself out as being, an entity or arrangement that raises
money from investors primarily for the purpose of investing in loans,
securities, swaps, funds or other assets for resale or other
disposition or otherwise trading in loans, securities, swaps, funds or
other assets. The Commission requests comment on the extent to which
there are (or may be in the future) pooled investment vehicles that are
not captured by the other prongs of the definition (such as the
provisions covering private funds under the Investment Advisers Act or
commodity pools under the CEA). The Commission also requests comment on
whether this aspect of the definition of financial end user provides
sufficiently clear guidance to covered swap entities and market
participants as to its intended scope, and whether it adequately
maintains a distinction between financial end users and commercial end
users.
Second, the proposal would allow the Commission to require a swap
dealer and major swap participant (“covered swap entity”) to treat an
entity as a financial end user for margin purposes, even if the person
is not specifically listed within the definition of “financial end
user” or if the entity is excluded from the definition of financial
end user as described below. This provision was included out of an
abundance of caution to act as a safety mechanism in the event that an
entity didn’t fall squarely within one of the listed categories but was
effectively acting as a financial end user.
To address the classification of foreign entities as financial end
users, the proposal would require the covered swap entity to determine
whether a foreign counterparty would fall within another prong of the
financial end user definition if the foreign entity was organized under
the laws of the United States or any State. The Commission recognizes
that this approach would impose upon covered swap entities the
difficulties associated with analyzing a foreign counterparty’s
business activities in light of a broad array of U.S. regulatory
requirements. The alternative, however, would require covered swap
entities to gather a foreign counterparty’s financial reporting data
and determine the relative amount of enumerated financial activities in
which the counterparty is engaged over a rolling period.29 The
Commission requests comment on whether some other method or approach
would adequately assure that the rule’s objectives with respect to
dealer safety and soundness and reductions of systemic risk can be
achieved, in a fashion that can be more readily operationalized by
covered swap entities. For example, would it be appropriate to have
foreign counterparties certify to CSEs whether they are financial end
users or not? This could be operationally simpler for the CSEs and
would avoid the circumstance where one CSE, in good faith, deemed a
foreign counterparty to be a financial end user and another CSE, in
good faith, did not.
—————————————————————————
29 See e.g., Definitions of “Predominantly Engaged In
Financial Activities” and “Significant Nonbank Financial Company
and Bank Holding Company”, 68 FR 20756 (April 5, 2013).
—————————————————————————
The definition of financial entities 30 would exclude the
government of any country, central banks, multilateral development
banks, the Bank for International Settlements, captive finance
companies,31 and agent affiliates.32 The exclusion for sovereign
entities, multilateral development banks and the Bank for International
Settlements is consistent with the 2013 international framework and the
proposal of the Prudential Regulators.
[[Page 59904]]
Captive finance companies and agent affiliates were excluded by the
Dodd-Frank Act from the definition of financial entity subject to
mandatory clearing.
—————————————————————————
30 Proposed Regulation Sec. 23.151.
31 A captive finance company is an entity that is excluded
from the definition of financial entity under section
2(h)(7)(c)(iii) of the CEA for purposes of the requirement to submit
certain swaps for clearing. That section describes it as “an entity
whose primary business is providing financing, and uses derivatives
for the purpose of hedging underlying commercial risks related to
interest rate and foreign currency exposures, 90 percent or more of
which arise from financing that facilitates the purchase or lease of
products, 90 percent or more of which are manufactured by the parent
company or another subsidiary of the parent company.”
32 An agent affiliate is an entity that is an affiliate of a
person that qualifies for an exception from the requirement to
submit certain trades for clearing. Under section 2(h)(7)(D) of the
CEA, “an affiliate of a person that qualifies for an exception
under subparagraph (A) (including affiliate entities predominantly
engaged in providing financing for the purchase of the merchandise
or manufactured goods of the person) may qualify for the exception
only if the affiliate, acting on behalf of the person and as an
agent, uses the swap to hedge or mitigate the commercial risk of the
person or other affiliate of the person that is not a financial
entity.”
—————————————————————————
The Commission notes that States would not be excluded from the
definition of financial end user, as the term “sovereign entity”
includes only central governments. The categorization of a State or
particular part of a State as a financial end user depends on whether
that part of the State is otherwise captured by the definition of
financial end user. For example, a State entity that is a
“governmental plan” under ERISA would meet the definition of
financial end user.
For a foreign entity that was not a central government, a foreign
regulator could request a determination whether the entity was a
financial end user. Such a determination could extend to other
similarly situated entities in that jurisdiction.
The Commission seeks comment on all aspects of the financial end
user definition, including whether the definition has succeeded in
capturing all entities that should be included. The Commission requests
comment on whether there are additional entities that should be
included as financial end users and, if so, how those entities should
be defined. Further, the Commission also requests comment on whether
there are additional entities that should be excluded from the
definition of financial end user and why those particular entities
should be excluded. The Commission also requests comment on whether
another approach to defining financial end user (e.g., basing the
financial end user definition on the financial entity definition as in
the 2011 proposal) would provide more appropriate coverage and clarity,
and whether covered swap entities could operationalize such an approach
as part of their regular procedures for taking on new counterparties.
The Commission requests comment on the costs and benefits of the
proposed definition of financial end user. Commenters are urged to
quantify the costs and benefits, if practicable. Commenters also may
suggest alternatives to the proposed approach where the commenters
believe that the alternatives would be appropriate under the CEA.
b. Small Banks
As noted above, banks would be financial end users under the
proposal. They would be subject to initial margin requirements if they
entered into uncleared swaps with CSEs and, as discussed below, had
material swaps exposure. Staff of the Prudential Regulators have
indicated that they expect that the proposed rule likely will have
minimal impact on small banks.
Staff of the Prudential Regulators believe that the vast majority
of small banks do not engage in swaps at or near that level of activity
that would meet the material swaps exposure threshold. If, however, a
small bank did exceed the threshold level, the Prudential Regulators
believe it would be appropriate for the protection of both the CSE and
the small bank for two-way initial margin to be posted. The Commission
notes that, as discussed in more detail below, initial margin would
only need to be posted to the extent it exceeded $65 million.
The proposed rule would require a CSE to exchange daily variation
margin with a small bank, regardless of whether the institution had
material swap exposure. However, the covered swap entity would only be
required to collect variation margin from a small bank when the amount
of both initial margin and variation margin required to be collected
exceeded $650,000. The Prudential Regulators have indicated that they
expect that the vast majority of small banks will have a daily margin
requirement that is below this amount.
The Commission requests comment on all aspects of the proposed
treatment of small banks. In particular, the Commission requests
comment on the interaction of this proposal with clearing exemptions
that have been granted.33
—————————————————————————
33 See Commission Regulations Sec. Sec. 50.50(d)(small
banks), 50.51 (cooperatives), 50.52 (inter-affiliate trades), and
CFTC Ltr. No. 13-22 (June 4, 2013) (treasury affiliates).
—————————————————————————
c. Affiliates of CSEs
The proposal generally would cover swaps between CSEs and their
affiliates that are financial end users. The Commission notes that
other applicable laws require transactions between banks and their
affiliates to be on an arm’s length basis. For example, section 23B of
the Federal Reserve Act provides that many transactions between a bank
and its affiliates must be on terms and under circumstances, including
credit standards, that are substantially the same or at least as
favorable to the bank as those prevailing at the time for comparable
transactions with or involving nonaffiliated companies.34 Consistent
with that treatment, the Prudential Regulators and the Commission are
proposing to apply the margin requirements to swaps between CSEs and
their affiliates.
—————————————————————————
34 12 U.S.C. 371c-1(a).
—————————————————————————
The Commission requests comment on all aspects of the proposed
treatment of transactions with affiliates. In particular, the
Commission requests comment on the interaction of this proposal with
clearing exemptions that have been granted.
d. Multilateral Development Banks
The proposed definition of the term “multilateral development
bank,” includes a provision encompassing “[a]ny other entity that
provides financing for national or regional development in which the
U.S. government is a shareholder or contributing member or which the
Commission determines poses comparable credit risk.” The Commission
seeks comment regarding this definition. In particular, is the
criterion of comparability of credit risk appropriate for this
definition? Should the Commission look to other characteristics of the
entity in determining whether it should be within the definition of
“multilateral development bank”?
e. Material Swaps Exposure
A CSE would not be required to exchange initial margin with a
financial end user if the financial end user did not have “material
swaps exposure.” 35 Material swaps exposure would be computed using
the average daily aggregate notional amount of uncleared swaps,
security-based swaps, foreign exchange forwards, and foreign exchange
swaps36 with all counterparties for June, July, and August of the
previous calendar year. Essentially, a financial end user would have
material swaps exposure if it held an aggregate gross notional amount
of these products of more than $3 billion.37
—————————————————————————
35 Proposed Regulation Sec. 23.152 applies to “covered
counterparties.” Proposed Regulation Sec. 23.151 defines that term
to include financial entities with material swaps exposure.
36 The 2013 international framework states that all uncleared
derivatives, “including physically settled FX forwards and swaps”
should be included in determining whether a covered entity should be
subject to margin requirements. BCBS/IOSCO Report Paragraph 8.8.
Although these products would not themselves be subject to margin
requirements, they are uncleared derivatives that pose risks. It was
the judgment of BCBS/IOSCO that they should be included in
identifying significant market participants in the uncleared space.
Consistent with international standards and with the Prudential
Regulators’ proposal, the Commission is proposing to include them
for purposes of this calculation.
37 Proposed Regulation Sec. 23.151.
—————————————————————————
This provision recognizes that a financial end user that has
relatively smaller positions does not pose the same risks as a
financial end user with
[[Page 59905]]
larger positions. By reducing the number of market participants subject
to certain margin requirements, it also addresses the concerns that
have been expressed about the availability of sufficient collateral to
meet these requirements.
While adoption of a material swaps exposure threshold is consistent
with the 2013 international framework,38 the Commission and the
Prudential Regulators, are proposing to set the materiality standard
lower than the international standard. However, the lower standard was
chosen in order to be consistent with the intent of the international
standards, which was to require collection of margin only when the
amount exceeds $65 million, as explained below.
—————————————————————————
38 BCBS/IOSCO Report at 9.
—————————————————————————
The 2013 international framework defines smaller financial end
users as those counterparties that have a gross aggregate amount of
covered swaps below [euro]8 billion, which, at current exchange rates,
is approximately equal to $11 billion. The preliminary view of the
Commission and the Prudential Regulators is that defining material
swaps exposure as a gross notional exposure of $3 billion, rather than
$11 billion, is appropriate because it reduces systemic risk without
imposing undue burdens on covered swap entities, and therefore, is
consistent with the objectives of the Dodd-Frank Act. This view is
based on data and analyses that have been conducted since the
publication of the 2013 international framework.
Specifically, the Commission and the Prudential Regulators have
reviewed actual initial margin requirements for a sample of cleared
swaps. These analyses indicate that there are a significant number of
cases in which a financial end user would have a material swaps
exposure level below $11 billion but would have a swap portfolio with
an initial margin collection amount that significantly exceeds the
proposed permitted initial margin threshold amount of $65 million. The
intent of both the Commission and the 2013 international framework is
that the initial margin threshold provide smaller counterparties with
relief from the operational burden of measuring and tracking initial
margin collection amounts that are expected to be below $65 million.
Setting the material swaps exposure threshold at $11 billion appears to
be inconsistent with this intent, based on the recent analyses.
The table below summarizes actual initial margin requirements for
4,686 counterparties engaged in cleared interest rate swaps. Each
counterparty represents a particular portfolio of cleared interest rate
swaps. Each counterparty had a swap portfolio with a total gross
notional amount less than $11 billion and each is a customer of a CCP’s
clearing member. Column (1) displays the initial margin amount as a
percentage of the gross notional amount. Column (2) reports the initial
margin, in millions of dollars that would be required on a portfolio
with a gross notional amount of $11 billion.
Initial Margin Amounts on 4,686 Cleared Interest Rate Swap Portfolios
—————————————————————————————————————-
Column (1) initial Column (2) initial
margin amount as margin amount on an $11
percentage of gross billion gross notional
notional amount (%) portfolio ($MM)
—————————————————————————————————————-
Average………………………………………………. 2.1 231
25th Percentile……………………………………….. 0.6 66
50th Percentile……………………………………….. 1.4 154
75th Percentile……………………………………….. 2.7 297
—————————————————————————————————————-
As shown in the table above, the average initial margin rate across
all 4,686 counterparties, reported in Column (1), is 2.1 percent, which
would equate to an initial margin collection amount, reported in Column
(2), of $231 million on an interest rate swap portfolio with a gross
notional amount of $11 billion. This average initial margin collection
amount significantly exceeds the proposed permitted threshold amount of
$65 million. Seventy-five percent of the 4,686 cleared interest rate
swap portfolios exhibit an initial margin rate in excess of 0.6
percent, which equates to an initial margin amount on a cleared
interest rate swap portfolio of $66 million (approximately equal to the
proposed permitted threshold amount).
The data above represent actual margin requirements on a sample of
interest rate swap portfolios that are cleared by a single CCP. Some
CCPs also provide information on the initial margin requirements on
specific and representative swaps that they clear. The Chicago
Mercantile Exchange (“CME”), for example, provides information on the
initial margin requirements for cleared interest rate swaps and credit
default swaps that it clears. This information does not represent
actual margin requirements on actual swap portfolios that are cleared
by the CME but does represent the initial margin that would be required
on specific swaps if they were cleared at the CME. The table below
presents the initial margin requirements for two swaps that are cleared
by the CME.
Initial Margin Amounts on CME Cleared Interest Rate and Credit Default Swaps
—————————————————————————————————————-
Column (1) initial Column (2) initial
margin amount as margin amount on an $11
percentage of gross billion gross notional
notional amount (%) portfolio ($MM)
—————————————————————————————————————-
5 year, receive fixed and pay floating rate interest rate swap 2.0 216
5 year, sold CDS protection on the CDX IG Series 20 Version 22 1.9 213
Index………………………………………………..
—————————————————————————————————————-
[[Page 59906]]
According to the CME, the initial margin requirement on the
interest rate swap and the credit default swap are both roughly two
percent of the gross notional amount. This initial margin rate
translates to an initial margin amount of roughly $216 million on a
swap portfolio with a gross notional amount of $11 billion.
Accordingly, this data also indicates that the initial margin
collection amount on a swap portfolio with a gross notional size of $11
billion could be significantly larger than the proposed permitted
initial margin threshold of $65 million.
In addition to the information provided in the tables above, the
Commission’s preliminary view is that additional considerations suggest
that the initial margin collection amounts associated with uncleared
swaps could be even greater than those reported in the tables above.
The tables above represent initial margin requirements on cleared
interest rate and credit default index swaps. Uncleared swaps in other
asset classes, such as single name equity or single name credit default
swaps, are likely to be riskier and hence would require even more
initial margin. In addition, uncleared swaps often contain complex
features, such as nonlinearities, that make them even riskier and would
hence require more initial margin. Finally, uncleared swaps are
generally expected to be less liquid than cleared swaps and must be
margined, under the proposed rule, according to a ten-day close-out
period rather than the five-day period required for cleared swaps. The
data presented above pertains to cleared swaps that are margined
according to a five-day and not a ten-day close-out period. The
requirement to use a ten-day close-out period would further increase
the initial margin requirements of uncleared versus cleared swaps.
In light of the data and considerations noted above, the
Commission’s preliminary view is that it is appropriate and consistent
with the intent of the 2013 international framework to identify a
material swaps exposure with a gross notional amount of $3 billion
rather than $11 billion ([euro]8 billion) as is suggested by the 2013
international framework. Identifying a material swaps exposure with a
gross notional amount of $3 billion is more likely to result in an
outcome in which entities with a gross notional exposure below the
material swaps exposure amount would be likely to have an initial
margin collection amount below the proposed permitted initial margin
threshold of $65 million. The Commission does recognize, however, that
even at the lower amount of $3 billion, there are likely to be some
cases in which the initial margin collection amount of a portfolio that
is below the material swaps exposure amount will exceed the proposed
permitted initial margin threshold amount of $65 million. The
Commission’s preliminary view is that such instances should be
relatively rare and that the operational benefits of using a simple and
transparent gross notional measure to define the material swaps
exposure amount are substantial.
The Commission notes that under the implementation schedule set out
below, this requirement would not take effect until January 1,
2019.39 Parties with gross notional exposures around this amount
would have several years notice before the requirements took effect.
—————————————————————————
39 Proposed Regulation Sec. 23.160.
—————————————————————————
The Commission requests comment on all aspects of the material
swaps exposure provision. In particular, the Commission requests
comment on the proposal to establish a level that is lower than the
level set forth in the 2013 international framework. Are there
alternative measurement methodologies that do not rely on gross
notional amounts that should be used? Does the proposed rule’s use and
definition of the material swaps exposure raise any competitive equity
issues that should be considered? Are there any other aspects of the
material swaps exposure that should be considered by the Commission?
The Commission requests comment on the costs and benefits of the
proposed definition of material swaps exposure. Commenters are urged to
quantify the costs and benefits, if practicable. Commenters also may
suggest alternatives to the proposed approach where the commenters
believe that the alternatives would be appropriate under the CEA.
3. Non-Financial End Users
Non-financial end users would include any entity that was not an
SD, an MSP, or a financial end user. The proposal would not require
CSEs to exchange margin with non-financial end users. The Commission
believes that such entities, which generally are using swaps to hedge
commercial risk, pose less risk to CSEs than financial entities.
Therefore, under section 4s(e)(3)(A)(ii) of the CEA, applying a
different standard to trades by CSEs with non-financial entities than
to trades by CSEs with covered counterparties would be “appropriate to
the risk.”
This approach is consistent with Congressional intent. Senior
Congressional leaders have stated that they do not believe that non-
financial end users should be required to post margin for uncleared
swaps.40 In addition, the Dodd-Frank Act generally exempted non-
financial end users from the requirement that they submit trades to
clearing.41 If the Commission required them to post margin for
uncleared trades, the clearing exemption could be weakened because the
costs of clearing are likely to be less than the costs of margining an
uncleared position. This approach is also consistent with international
standards.42
—————————————————————————
40 Letter from Chairman Debbie Stabenow, Committee on
Agriculture, Nutrition and Forestry, U.S. Senate, Chairman Frank D.
Lucas, Committee on Agriculture, United States House of
Representatives, Chairman Tim Johnson, Committee on Banking,
Housing, and Urban Affairs, U.S. Senate, and Chairman Spencer
Bachus, Committee on Financial Services, United States House of
Representatives to Secretary Timothy Geithner, Department of
Treasury, Chairman Gary Gensler, U.S. Commodity Futures Trading
Commission, Chairman Ben Bernanke, Federal Reserve Board, and
Chairman Mary Shapiro, U.S. Securities and Exchange Commission
(April 6, 2011); Letter from Chairman Christopher Dodd, Committee on
Banking, Housing, and Urban Affairs, U.S. Senate, and Chairman
Blanche Lincoln, Committee on Agriculture, Nutrition, and Forestry,
U.S. Senate, to Chairman Barney Frank, Financial Services Committee,
United States House of Representatives, and Chairman Collin
Peterson, Committee on Agriculture, United States House of
Representatives (June 30, 2010); see also 156 Cong. Rec. S5904
(daily ed. July 15, 2010) (statement of Sen. Lincoln).
41 See section 2(h)(7) of the CEA.
42 BCBS/IOSCO Report at pp. 7-8.
—————————————————————————
The Commission’s proposal is generally consistent with the proposal
of the Prudential Regulators but differs in some particulars. The
Prudential Regulators’ proposal contains the following provision:
A covered swap entity is not required to collect initial margin
with respect to any non-cleared swap or non-cleared security-based
swap with a counterparty that is neither a financial end user with
material swaps exposure nor a swap entity but shall collect initial
margin at such times and in such forms (if any) that the covered
swap entity determines appropriately address the credit risk posed
by the counterparty and the risks of such non-cleared swaps and non-
cleared security-based swaps.
The Commission’s proposal does not contain this provision.
The Commission’s proposal contains other provisions designed to
address the mandate under section 4s(e)(3)(A)(i) that Commission rules
“help ensure the safety and soundness” of SDs and MSPs. First, as
discussed further below, the rules would require CSEs to enter into
certain documentation with all counterparties, including non-financial
entities, to provide clarity about the parties’ respective rights and
obligations.43 CSEs and non-financial
[[Page 59907]]
entities would be free to set initial margin and variation margin
requirements, if any, in their discretion and any thresholds agreed
upon by the parties would be permitted.
—————————————————————————
43 Proposed Regulation Sec. 23.158.
—————————————————————————
Second, the proposal would require each CSE to calculate
hypothetical initial and variation margin amounts each day for
positions held by non-financial entities that have material swaps
exposure to the covered counterparty.44 That is, the CSE must
calculate what the margin amounts would be if the counterparty were
another SD or MSP and compare them to any actual margin requirements
for the positions.45 These calculations would serve as risk
management tools to assist the CSE in measuring its exposure and to
assist the Commission in conducting oversight of the CSE.
—————————————————————————
44 Proposed Regulations Sec. Sec. 23.154(a)(6) and
23.155(a)(3).
45 This is consistent with the requirement set forth in
section 4s(h)(3)(B)(iii)(II) of the CEA that SDs and MSPs must
disclose to counterparties who are not SDs or MSPs a daily mark for
uncleared swaps.
—————————————————————————
D. Nature and Timing of Margin Requirements
1. Initial Margin
Subject to thresholds discussed below, the proposal would require
each CSE to collect initial margin from, and to post initial margin
with, each covered counterparty on or before the business day after
execution 46 for every swap with that counterparty.47 The proposal
would require the CSEs to continue to post and to collect initial
margin until the swap is terminated or expires.48
—————————————————————————
46 Commission Regulation Sec. 23.200(e) defines execution to
mean, “an agreement by the counterparties (whether orally, in
writing, electronically, or otherwise) to the terms of the swap
transaction that legally binds the counterparties to such terms
under applicable law.” 17 CFR 23.200(e).
47 Proposed Regulation Sec. 23.152(a).
48 Proposed Regulation Sec. 23.152(b).
—————————————————————————
Recognizing that SDs and MSPs pose greater risk to the markets and
the financial system than other swap market participants, Congress
established a comprehensive regulatory scheme for them including
registration, recordkeeping, reporting, margin, capital, and business
conduct requirements. Accordingly, under the mandate of section
4s(e)(3)(C) to preserve the financial integrity of markets trading
swaps and to preserve the stability of the United States financial
system, the Commission is proposing to require SDs and MSPs to collect
initial margin from, and to post initial margin with, one another.
Similarly, as discussed above, the Commission believes that
financial end users with material swaps exposure potentially pose
greater risk to CSEs and to the financial system than non-financial end
users or financial end users with smaller aggregate exposures.
Accordingly, under the mandate of section 4s(e)(3)(A) to help ensure
the safety and soundness of SDs and MSPs, the Commission is proposing
to require SDs and MSPs to collect initial margin from, and to post
initial margin with, financial end users.
Notably, the proposal would require both collecting and posting of
initial margin by CSEs (“two-way margin”). Two-way margin helps to
ensure the safety and soundness of CSEs. Daily collection of initial
margin increases the safety and soundness of the CSE by providing
collateral to cover potential future exposure from each counterparty.
That is, if a counterparty fails to meet an obligation, the CSE can
liquidate the initial margin that it holds to cover some or all of the
loss. But daily posting of initial margin also helps to ensure the
safety and soundness of a CSE by making it more difficult for the CSE
to build up exposures that it cannot fulfill. That is, the requirement
that a CSE post initial margin acts as a discipline on its risk taking.
The requirement also would make it more difficult for a rogue trader to
hide his positions.
In the wake of clearing mandates, uncleared swaps are likely to be
more customized and consequently trade in a less liquid market than
cleared swaps. As a result, uncleared swaps potentially might take a
longer time and require a greater price premium to be liquidated than
cleared swaps, particularly in distressed market conditions. Initial
margin is designed to address these risks.
The proposal contains a provision stating that a CSE would not be
deemed to have violated its obligation to collect initial margin if it
took certain steps.49 Specifically, if a counterparty failed to pay
the required initial margin to the CSE, the CSE would be required to
make the necessary efforts to attempt to collect the initial margin,
including the timely initiation and continued pursuit of formal dispute
resolution mechanisms,50 or otherwise demonstrate upon request to the
satisfaction of the Commission that it has made appropriate efforts to
collect the required initial margin or commenced termination of the
swap.
—————————————————————————
49 Proposed Regulation Sec. 23.152(c).
50 See Commission Regulation Sec. 23.504(b)(4).
—————————————————————————
The Commission requests comment on all aspects of the proposal
relating to the nature and timing of initial margin. In particular, the
Commission requests comment on two-way initial margin.
The Commission requests comment on the costs and benefits of the
proposed approach. Commenters are urged to quantify the costs and
benefits, if practicable. Commenters also may suggest alternatives to
the proposed approach where the commenters believe that the
alternatives would be appropriate under the CEA.
2. Variation Margin
Subject to a minimum transfer amount discussed below, the proposal
would require each CSE to collect variation margin from, and to pay
variation margin to, each counterparty that is a swap entity or a
financial end user, on or before the end of the business day after
execution for each swap with that counterparty.51 The proposed rule
would require the CSEs to continue to pay or collect variation margin
each business day until the swap is terminated or expires.52
—————————————————————————
51 Proposed Regulation Sec. 23.153(a).
52 Proposed Regulation Sec. 23.153(b).
—————————————————————————
Two-way variation margin would protect the safety and soundness of
CSEs for the same reasons discussed above in connection with initial
margin. Two-way variation margin has been a keystone of the ability of
DCOs to manage risk. Each day, starting on the day after execution,
current exposure is removed from the market through the payment and
collection of variation margin.
If two-way variation margin were not required for uncleared swaps
between CSEs and counterparties that are swap entities or financial end
users, current exposures might accumulate beyond the financial capacity
of a counterparty. In contrast to initial margin, which is designed to
cover potential future exposures, variation margin addresses actual
current exposures, that is, losses that have already occurred.
Unchecked accumulation of such exposures was one of the characteristics
of the financial crisis which, in turn, led to the enactment of the
Dodd-Frank Act.53 As with initial margin, the Commission believes
that requiring covered swap entities both to collect and pay margin
with these counterparties effectively reduces systemic risk by
protecting both the covered swap entity and its
[[Page 59908]]
counterparty from the effects of a default.
—————————————————————————
53 See The Financial Crisis Inquiry Commission, The Financial
Crisis Inquiry Report: Final Report of the National Commission on
the Causes of the Financial and Economic Crisis in the United States
(Official Government Edition) at 265-268 (2011), available at http://fcic-static.law.stanford.edu/cdn_media/fcic-reports/fcic_final_report_full.pdf.
—————————————————————————
In contrast to the initial margin requirement, which would only
apply to financial end users with material swaps exposure, the proposed
variation margin requirement would apply to all financial end users
regardless of whether the entity had material swaps exposure. This is
consistent with international standards.54 It reflects the
Commission’s view that variation margin is an important risk mitigant
that (i) reduces the build-up of risk that may ultimately pose systemic
risk and (ii) imposes a lesser liquidity burden than does initial
margin. Moreover, this approach is consistent with current market
practice.
—————————————————————————
54 BCBS/IOSCO Report at 9.
—————————————————————————
The proposal would permit netting of variation margin across
swaps.55 Any netting would have to be done pursuant to an eligible
master netting agreement.56 The agreement would create a single legal
obligation for all individual transactions covered by the agreement
upon an event of default. It would specify the rights and obligations
of the parties under various circumstances.57
—————————————————————————
55 Proposed Regulation Sec. 23.153(c).
56 Proposed Regulation Sec. 23.151, definition of “eligible
master netting agreement.”
57 Id.
—————————————————————————
As is the case for initial margin, the proposal contains a
provision stating that a CSE would not be deemed to have violated its
obligation to collect variation margin if it took certain steps.58
Specifically, if a counterparty failed to pay the required variation
margin to the CSE, the CSE would be required to make the necessary
efforts to attempt to collect the variation margin, including the
timely initiation and continued pursuit of formal dispute resolution
mechanisms, including pursuant to Commission Regulation 23.504(b)(4),
if applicable, or otherwise demonstrate upon request to the
satisfaction of the Commission that it has made appropriate efforts to
collect the required variation margin or commenced termination of the
swap.
—————————————————————————
58 Proposed Regulation Sec. 23.153(d).
—————————————————————————
The Commission requests comment on all aspects of the proposal
relating to the nature and timing of variation margin.
The Commission requests comment on the costs and benefits of the
proposed approach. Commenters are urged to quantify the costs and
benefits, if practicable. Commenters also may suggest alternatives to
the proposed approach where the commenters believe that the
alternatives would be appropriate under the CEA.
E. Calculation of Initial Margin
1. Overview
Under the proposed rules, a CSE could calculate initial margin
using either a model-based method or a standardized table-based
method.59 The required amount of initial margin would be the amount
computed pursuant to the model or the table minus a threshold amount of
$65 million.60 This amount could not be less than zero.61 The
initial margin specified under the rule would be a minimum requirement,
and the parties would be free to require more initial margin.
—————————————————————————
59 Proposed Regulation Sec. 23.154.
60 Proposed Regulation Sec. 23.151, definition of “initial
margin threshold amount.”
61 Proposed Regulation Sec. 23.154(a)(4).
—————————————————————————
When a CSE entered into a swap with a counterparty that was either
another CSE or an SD/MSP subject to a Prudential Regulator, each party
would bear the responsibility for calculating the amount that it would
collect.62 Thus, for such trades, the amount a party posted could
differ from the amount it collected either because of differences in
their respective methodologies or because the product has asymmetric
risk. As a practical matter, the Commission understands that the
industry is working to develop common standards that would minimize
this for methodologies.
—————————————————————————
62 Proposed Regulation Sec. 23.152(a).
—————————————————————————
When, however, a CSE entered into a swap with a financial entity,
the CSE would have responsibility for calculating both the amount it
collected and the amount it posted.63 This is because the statute
does not directly impose margin requirements on financial entities.
They only come within the scope of section 4s when they trade with SDs
or MSPs.
—————————————————————————
63 Proposed Regulation Sec. 23.154(b).
—————————————————————————
As noted, the rules would permit CSEs and their covered
counterparties to establish margin thresholds of up to $65 million.
This means that the parties could agree not to post and/or to collect
any margin amount falling below this threshold level. For covered
entities that were part of a consolidated group, a single threshold
would be applied across the consolidated group, not individually to
each entity.64 This threshold is consistent with the 50 million Euro
threshold set forth in the international standards as is the
consolidated group requirement.65 The Prudential Regulators proposed
the same treatment in this regard.
—————————————————————————
64 Proposed Regulation Sec. 23.151, definition of “initial
margin threshold amount.”
65 BCBS/IOSCO Report at 9.
—————————————————————————
Concern has been expressed by some in the industry about the
potential expense of two-way margin. The $65 million threshold is
designed to mitigate that expense while continuing to protect the
financial integrity of CSEs and the financial system. Smaller exposures
would be permitted to go uncollateralized, but a significant percentage
of all large exposures would be supported by collateral.
For example, if the initial margin calculated for a particular
trade were $55 million, the CSE would not be required to post or to
collect initial margin because the amount would be below the $65
million threshold. If the margin amount were $75 million, the CSE would
only be required to post and to collect $10 million, the amount the
margin calculation exceeded the $65 million threshold.
In order to reduce transaction costs, the proposal would establish
a “minimum transfer amount” of $650,000.66 Initial and variation
margin payments would not be required to be made if the payment were
below that amount. This amount is consistent with international
standards.67 It represents an amount sufficiently small that the
level of risk reduction might not be worth the transaction costs of
transferring the money. It would affect only the timing of collection;
it would not change the amount of margin that must be collected once
the $650,000 level was exceeded.
—————————————————————————
66 Proposed Regulation Sec. 23.154(a)(3).
67 BCBS/IOSCO Report at 9.
—————————————————————————
For example, if a party posted $80 million as initial margin on
Monday and the requirement increased to $80,400,000 on Tuesday, the
party would not be required to post additional funds on Tuesday because
the $400,000 increase would be less than the minimum transfer amount.
If, however, on Wednesday, the requirement increased by another
$400,000 to $80,800,000, the party would be required to post the entire
$800,000 additional amount.
The Commission requests comment on the $65 million threshold and
the $650,000 minimum transfer amount. The Commission requests comment
on the costs and benefits of the proposed approach. Commenters are
urged to quantify the costs and benefits, if practicable. Commenters
also may suggest alternatives to the proposed approach where the
commenters believe that the alternatives would be appropriate under the
CEA.
[[Page 59909]]
2. Models
a. Commission Approval
Consistent with international standards, the proposal would require
CSEs to obtain the written approval of the Commission before using a
model to calculate initial margin.68 Further, the CSE would have to
demonstrate that the model satisfied all of the requirements of this
section on an ongoing basis.69 In addition, a CSE would have to
notify the Commission in writing before extending the use of a model
that has been approved to an additional product type, making any change
to any initial margin model that has been approved that would result in
a material change in the CSE’s assessment of initial margin
requirements; or making any material change to assumptions used in the
model.70 The Commission could rescind its approval of a model if the
Commission determined that the model no longer complied with this
section.71
—————————————————————————
68 Proposed Regulation Sec. 23.154(b)(1). See BCBS/IOSCO
Report at 12: “any quantitative model that is used for initial
margin purposes must be approved by the relevant supervisory
authority.”
69 Id.
70 Id.
71 Id.
—————————————————————————
Given the central place of modeling in most margin systems and the
complexity of the process, the Commission believes that these oversight
provisions are necessary. The resources that would be needed, however,
to initially review and to periodically assess margin models present a
significant challenge to the Commission. To address this issue, the
Commission would seek to coordinate with both domestic and foreign
authorities in the review of models.
In many instances, CSEs whose margin models would be subject to
Commission review would be affiliates of entities whose margin models
would be subject to review by one of the Prudential Regulators. In such
situations, the Commission would coordinate with the Prudential
Regulators in order to avoid duplicative efforts and to provide
expedited approval of models that a Prudential Regulator had already
approved. For example, if a Prudential Regulator had approved the model
of a depository institution registered as an SD, Commission review of a
comparable model used by a non-bank affiliate of that SD would be
greatly facilitated. Similarly, the Commission would coordinate with
the SEC for CSEs that are dually registered and would coordinate with
foreign regulators that had approved margin models for foreign CSEs.
For CSEs that that wished to use models that were not reviewed by a
Prudential Regulator, the SEC, or a foreign regulator, the Commission
would coordinate, if possible, with the National Futures Association
(“NFA”) as each CSE would be required to be a member of the NFA.
The Commission requests comment on all aspects of the proposed
margin approval process. Specifically, the Commission requests comment
on the appropriateness and feasibility of coordinating with the
Prudential Regulators, the SEC, foreign regulators, and the NFA in this
regard.
The Commission is also considering whether it would be appropriate
to provide for provisional approval upon the filing of an application
pending review. The Commission requests comment on the appropriateness
of such an approach.
In order to expedite the review of models further, the Commission
is proposing to delegate authority to staff to perform the functions
described above. As is the case with existing delegations to staff, the
Commission would continue to reserve the right to perform these
functions itself at any time.
The Commission requests comment on whether additional procedural
detail is appropriate. For example, should time frames be specified for
completion of any of the functions?
b. Applicability to Multiple Swaps
To the extent that more than one uncleared swap is executed
pursuant to an eligible master netting agreement (“EMNA”) 72
between a CSE and a covered counterparty, the CSE would be permitted to
calculate initial margin on an aggregate basis with respect to all
uncleared swaps governed by such agreement.73 As explained below,
however, only exposures in certain asset classes could be offset. If
the agreement covered uncleared swaps entered into before the
applicable compliance date, those swaps would have to be included in
the calculation.74
—————————————————————————
72 This term is defined in Proposed Regulation Sec. 23.151.
73 Proposed Regulation Sec. 23.154(b)(2).
74 Id.
—————————————————————————
The proposal defines EMNA as any written, legally enforceable
netting agreement that creates a single legal obligation for all
individual transactions covered by the agreement upon an event of
default (including receivership, insolvency, liquidation, or similar
proceeding) provided that certain conditions are met. These conditions
include requirements with respect to the covered swap entity’s right to
terminate the contract and to liquidate collateral and certain
standards with respect to legal review of the agreement to ensure that
it meets the criteria in the definition.
The Commission requests comment on all aspects of the proposed
definition of EMNA. In particular, the Commission requests comment on
whether the proposal provides sufficient clarity regarding the laws of
foreign jurisdictions that provide for limited stays to facilitate the
orderly resolution of financial institutions. The Commission also seeks
comment regarding whether the provision for a contractual agreement
subject by its terms to limited stays under resolution regimes
adequately encompasses potential contractual agreements of this nature
or whether this provision needs to be broadened, limited, clarified, or
modified in some manner.
c. Elements of a Model
The proposal specifies a number of conditions that a model would
have to meet to receive Commission approval.75 They include, among
others, the following.
—————————————————————————
75 Proposed Regulation Sec. 23.154(b)(3).
—————————————————————————
(i) Ten-Day Close-Out Period
The model must calculate potential future exposure using a one-
tailed 99 percent confidence interval for an increase in the value of
the uncleared swap or netting set of uncleared swaps due to an
instantaneous price shock that is equivalent to a movement in all
material underlying risk factors, including prices, rates, and spreads,
over a holding period equal to the shorter of ten business days or the
maturity of the swap.
The required 10-day close-out period assumption is consistent with
counterparty credit risk capital requirements for banks. The
calculation must be performed directly over a 10-day period. In the
context of bank regulatory capital rules, a long horizon calculation
(such as 10 days), under certain circumstances, may be indirectly
computed by making a calculation over a shorter horizon (such as 1 day)
and then scaling the result of the shorter horizon calculation to be
consistent with the longer horizon. The proposed rule does not provide
this option to covered swap entities using an approved initial margin
model. The Commission’s understanding is that the rationale for
allowing such indirect calculations that rely on scaling shorter
horizon calculations has largely been based on computational and cost
considerations that were material in the
[[Page 59910]]
past but are much less so in light of advances in computational speeds
and reduced computing costs. The Commission seeks comment on whether
the option to make use of such indirect calculations has a material
effect on the burden of complying with the proposed rule, and whether
such indirect methods are appropriate in light of current computing
methods and costs.
(ii) Portfolio Offsets
The model may reflect offsetting exposures, diversification, and
other hedging benefits for uncleared swaps that are governed by the
same EMNA by incorporating empirical correlations within the broad risk
categories, provided the covered swap entity validates and demonstrates
the reasonableness of its process for modeling and measuring hedging
benefits. The categories are agriculture, credit, energy, equity,
foreign exchange/interest rate, metals, and other. Empirical
correlations under an eligible master netting agreement may be
recognized by the model within each broad risk category, but not across
broad risk categories. The sum of the initial margins calculated for
each broad risk category must be used to determine the aggregate
initial margin due from the counterparty.
For example, if a CSE entered into two credit swaps and two energy
swaps with a single counterparty, the CSE could use an approved initial
margin model to perform two separate calculations: the initial margin
calculation for the credit swaps and the initial margin calculation for
the energy commodity swaps. Each calculation could recognize offsetting
and diversification within the credit swaps and within the energy
commodity swaps. The result of the two separate calculations would then
be summed together to arrive at the total initial margin amount for the
four swaps (two credit swaps and two energy commodity swaps).
The Commission believes that the correlations of exposures across
unrelated asset categories, such as credit and energy commodities, are
not stable enough over time, and, in particular, during periods of
financial stress, to be recognized in a regulatory margin model
requirement. The Commission further believes that a single commodity
asset class is too broad and that the relationship between disparate
commodity types, such as aluminum and corn, are not stable enough to
warrant hedging benefits within the initial margin model. The
Commission seeks comment on this specific treatment of asset classes
for initial margin purposes and whether fewer or more distinctions
should be made.
The Commission is aware that some swaps may be difficult to
classify into one and only one asset class because some swaps may have
characteristics that relate to more than one asset class. Under the
proposal, the Commission expects that the CSE would make a
determination as to which asset class best represents the swap based on
a holistic view of the underlying swap. As a specific example, many
swaps may have some sensitivity to interest rates even though most of
the swap’s sensitivity relates to another asset class such as equity or
credit. The Commission seeks comment on whether or not this approach is
reasonable and whether or not instances in which the classification of
a swap into one of the broad asset classes described above is
problematic and material. If such instances are material, the
Commission seeks comment on alternative approaches to dealing with such
swaps.
(iii) Stress Calibration
The proposed rule requires the initial margin model to be
calibrated to a period of financial stress. In particular, the initial
margin model must employ a stress period calibration for each broad
asset class (agricultural commodity, energy commodity, metal commodity,
other commodity, credit, equity, and interest rate and foreign
exchange). The stress period calibration employed for each broad asset
class must be appropriate to the specific asset class in question.
While a common stress period calibration may be appropriate for some
asset classes, a common stress period calibration for all asset classes
would only be considered appropriate if it is appropriate for each
specific underlying asset class. Also, the time period used to inform
the stress period calibration must include at least one year, but no
more than five years, of equally-weighted historical data.
This proposed requirement is intended to balance the tradeoff
between shorter and longer data spans. Shorter data spans are sensitive
to evolving market conditions but may also overreact to short-term and
idiosyncratic spikes in volatility. Longer data spans are less
sensitive to short-term market developments but may also place too
little emphasis on periods of financial stress, resulting in
requirements that are too low. The requirement that the data be equally
weighted is intended to establish a degree of consistency in model
calibration while also ensuring that particular weighting schemes do
not result in excessive margin requirements during short-term bouts of
heightened volatility.
The model must use risk factors sufficient to measure all material
price risks inherent in the transactions for which initial margin is
being calculated. The risk categories must include, but should not be
limited to, foreign exchange or interest rate risk, credit risk, equity
risk, agricultural commodity risk, energy commodity risk, metal
commodity risk, and other commodity risk, as appropriate. For material
exposures in significant currencies and markets, modeling techniques
must capture spread and basis risk and incorporate a sufficient number
of segments of the yield curve to capture differences in volatility and
imperfect correlation of rates along the yield curve.
The initial margin model must include all material risks arising
from the nonlinear price characteristics of option positions or
positions with embedded optionality and the sensitivity of the market
value of the positions to changes in the volatility of the underlying
rates, prices, or other material risk factors.
(iv) Frequency of Margin Calculation
The proposed rule requires daily calculation of initial margin. The
use of an approved initial margin model may result in changes to the
initial margin amount on a daily basis for a number of reasons.
First, the characteristics of the swaps that have a material effect
on their risk may change over time. As an example, the credit quality
of a corporate reference entity upon which a credit default swap
contract is written may undergo a measurable decline.
Second, any change to the composition of the swap portfolio that
results in the addition or deletion of swaps from the portfolio would
result in a change in the initial margin amount.
Third, the underlying parameters and data that are used in the
model may change over time as underlying conditions change. For
example, a new period of financial stress may be encountered in one or
more asset classes. While the stress period calibration is intended to
reduce the extent to which small or moderate changes in the risk
environment influence the initial margin model’s risk assessment, a
significant change in the risk environment that affects the required
stress period calibration could influence the margin model’s overall
assessment of the risk of a swap.
Fourth, quantitative initial margin models are expected to be
maintained and refined on a continuous basis to
[[Page 59911]]
reflect the most accurate risk assessment possible with available best
practices and methods. As best practice risk management models and
methods change, so too may the risk assessments of initial margin
models.
(v) Benchmarking
The proposed rule requires that a model used for calculating
initial margin requirements be benchmarked periodically against
observable margin standards to ensure that the initial margin required
is not less than what a CCP would require for similar transactions.76
This benchmarking requirement is intended to ensure that any initial
margin amount produced by a model is subject to a readily observable
minimum. It will also have the effect of limiting the extent to which
the use of models might disadvantage the movement of certain types of
swaps to DCOs by setting lower initial margin amounts for uncleared
transactions than for similar cleared transactions.
—————————————————————————
76 Proposed Regulation Sec. 23.154(b)(5).
—————————————————————————
d. Control Mechanisms
The proposal would require CSEs to implement certain control
mechanisms.77 They include, among others, the following.
—————————————————————————
77 Proposed Regulation Sec. 23.154(b)(5).
—————————————————————————
The CSE must maintain a risk management unit in accordance with
existing Commission Regulation 23.600(c)(4)(i) that reports directly to
senior management and is independent from the business trading
units.78 The unit must validate its model before implementation and
on an ongoing basis. The validation process must include an evaluation
of the conceptual soundness of the model, an ongoing monitoring process
to ensure that the initial margin is not less than what a DCO would
require for similar cleared products, and back testing.
—————————————————————————
78 Commission Regulation Sec. 23.600 requires each registered
SD/MSP to establish a risk management program that identifies the
risks implicated by the SD/MSP’s activities along with the risk
tolerance limits set by the SD/MSP. The SD/MSP should take into
account a variety of risks, including market, credit, liquidity,
foreign currency, legal, operational, settlement, and other
applicable risks. The risks would also include risks posed by
affiliates. See 17 CFR 23.600.
—————————————————————————
If the validation process revealed any material problems with the
model, the CSE would be required to notify the Commission of the
problems, describe to the Commission any remedial actions being taken,
and adjust the model to insure an appropriate amount of initial margin
is being calculated.
The CSE must have an internal audit function independent of the
business trading unit that at least annually assesses the effectiveness
of the controls supporting the model. The internal audit function must
report its findings to the CSE’s governing body, senior management, and
chief compliance officer at least annually.
Given the complexity of margin models and the incentives to
calculate lower margin amounts, the Commission believes that rigorous
internal oversight is necessary to ensure proper functioning.
The Commission seeks comment on all aspects of the proposed
standards for models and the proposed levels of regulatory review.
The Commission requests comment on the costs and benefits of the
proposed approach. Commenters are urged to quantify the costs and
benefits, if practicable. Commenters also may suggest alternatives to
the proposed approach where the commenters believe that the
alternatives would be appropriate under the CEA.
3. Table-Based Method
a. Method of Calculation
Some CSEs might not have the internal technical resources to
develop initial margin models or have simple portfolios for which they
want to avoid the complexity of modeling. The table-based method would
allow a CSE to calculate its initial margin requirements using a
standardized table.79 The table specifies the minimum initial margin
amount that must be collected as a percentage of a swap’s notional
amount. This percentage varies depending on the asset class of the
swap. Except as described below, a CSE would be required to calculate a
minimum initial margin amount for each swap and sum up all the minimum
initial margin amounts calculated under this section to arrive at the
total amount of initial margin. The table is consistent with
international standards.80
—————————————————————————
79 Proposed Regulation Sec. 23.154(c).
80 BCBS/IOSCO Report at Appendix A.
—————————————————————————
b. Net-to-Gross Ratio Adjustment
The Commission recognizes that using a notional amount measure of
initial margin without any adjustment for offsetting exposures,
diversification, and other hedging benefits might not accurately
reflect the size or risks of a CSE’s swap-based positions in many
situations. Moreover, not adequately recognizing the benefits of
offsets, diversification, and hedging might lead to large disparities
between model-based and table-based initial margin requirements. These
disparities might give rise to inequities between CSEs that elect to
use an approved model and CSEs that rely on the table for computing
their respective initial margin requirements.
To address these potential inequities, the Commission is proposing
an adjustment to the table-based initial margin requirement.
Specifically, the Commission would allow a CSE to calculate a net-to-
gross ratio adjustment.81
—————————————————————————
81 This calculation is set forth in proposed Regulation Sec.
23.154(c)(2).
—————————————————————————
The net-to-gross ratio compares the net current replacement cost of
the uncleared portfolio (in the numerator) with the gross current
replacement cost of the uncleared portfolio (in the denominator). The
net current replacement cost is the cost of replacing the entire
portfolio of swaps that is covered under an eligible master netting
agreement. The gross current replacement cost is the cost of replacing
those swaps that have a strictly positive replacement cost.
For example, consider a portfolio that consists of two uncleared
swaps in which the mark-to-market value of the first swap is $10 (i.e.,
the CSE is owed $10 from its counterparty) and the mark-to-market value
of the second swap is -$5 (i.e., the CSE owes $5 to its counterparty).
The net current replacement cost is $5 ($10-$5), the gross current
replacement cost is $10, and the net-to-gross ratio would be 5/10 or
0.5.82
—————————————————————————
82 Note that in this example, whether or not the
counterparties have agreed to exchange variation margin has no
effect on the net-to-gross ratio calculation, i.e., the calculation
is performed without considering any variation margin payments. This
is intended to ensure that the net-to-gross ratio calculation
reflects the extent to which the uncleared swaps generally offset
each other and not whether the counterparties have agreed to
exchange variation margin. As an example, if a swap dealer engaged
in a single sold credit derivative with a counterparty, then the
net-to-gross calculation would be 1.0 whether or not the dealer
received variation margin from its counterparty.
—————————————————————————
The net-to-gross ratio and gross standardized initial margin
amounts provided in the table are used in conjunction with the notional
amount of the transactions in the underlying swap portfolio to arrive
at the total initial margin requirement as follows:
Standardized Initial Margin = 0.4 x Gross Initial Margin + 0.6 x
NGR x Gross Initial Margin
where:
Gross Initial Margin = the sum of the notional value multiplied by
the applicable initial margin requirement percentage from the table A
for each uncleared swap in the portfolio
and
[[Page 59912]]
NGR = Net-to-Gross Ratio
The Commission notes that the calculation of the net-to-gross ratio
for margin purposes must be applied only to swaps subject to the same
EMNA and that the calculation is performed across transactions in
disparate asset classes within a single netting agreement. (Thus, all
non-cleared swaps subject to the same EMNA can be netted against each
other in the calculation of the net-to-gross ratio. By contrast, under
a model, netting is only permitted within each asset class). This
approach is consistent with the standardized counterparty credit risk
capital requirements.
The Commission also notes that if a counterparty maintains multiple
swap portfolios under multiple EMNAs, the standardized initial margin
amounts would be calculated separately for each portfolio with each
calculation using the gross initial margin and net-to-gross ratio that
is relevant to each portfolio. The total standardized initial margin
would be the sum of the standardized initial margin amounts for each
portfolio.
The proposed net-to-gross ratio adjustment is consistent with
international standards.83 The proposed table and adjustment are the
same as the Prudential Regulators’ proposal.
—————————————————————————
83 BCBS/IOSCO Report at 13.
—————————————————————————
The Commission seeks comment on all aspects of the proposed table-
based approach. The Commission notes that the BCBS has recently adopted
a new method for the purpose of capitalizing counterparty credit
risk.84 The Commission seeks comment on whether the BCBS’s recently
adopted standardized approach would represent a material improvement
relative to the proposed method that employs the net-to-gross ratio.
—————————————————————————
84 See the Basel Committee on Banking Supervision, “The
standardized approach for measuring counterparty credit risk
exposures,” (March 31, 2014), available at http://www.bis.org/publ/bcbs279.pdf.
—————————————————————————
The Commission requests comment on the costs and benefits of the
proposed approach. Commenters are urged to quantify the costs and
benefits, if practicable. Commenters also may suggest alternatives to
the proposed approach where the commenters believe that the
alternatives would be appropriate under the CEA.
F. Calculation of Variation Margin
1. Means of Calculation
Under the proposal, each CSE would be required to calculate
variation margin for itself and for each covered counterparty using a
methodology and inputs that to the maximum extent practicable and in
accordance with existing Regulation 23.504(b)(4) rely on recently-
executed transactions, valuations provided by independent third
parties, or other objective criteria.85 In addition, each CSE would
have to have in place alternative methods for determining the value of
an uncleared swap in the event of the unavailability or other failure
of any input required to value a swap.86
—————————————————————————
85 Proposed Regulation Sec. 23.155(a)(1) and Commission
Regulation Sec. 23.504(b)(4).
86 Proposed Regulation Sec. 23.155(a)(2).
—————————————————————————
2. Control Mechanisms
The proposal would also set forth several control mechanisms.87
Each CSE would be required to create and maintain documentation setting
forth the variation margin methodology with sufficient specificity to
allow the counterparty, the Commission, and any applicable Prudential
Regulator to calculate a reasonable approximation of the margin
requirement independently. Each CSE would be required to evaluate the
reliability of its data sources at least annually, and make
adjustments, as appropriate. The proposal would permit the Commission
to require a CSE to provide further data or analysis concerning the
methodology or a data source.
—————————————————————————
87 Proposed Regulation Sec. 23.155(b).
—————————————————————————
These provisions are consistent with international standards 88
and the Prudential Regulators’ proposed rules. The Commission’s
proposal, however, sets forth more detailed requirements. These
requirements are consistent with an approach currently under
consideration by an IOSCO working group.
—————————————————————————
88 BCBS/IOSCO Report at 14-15.
—————————————————————————
The Commission believes that the accurate valuation of positions
and the daily payment of variation margin to remove accrued risk is a
critical element in assuring the safety and soundness of CSEs and in
preserving the financial integrity of the markets. The Commission
believes that its experience with cleared markets 89 coupled with the
problems in the uncleared markets noted in section II.A. demonstrates
this.
—————————————————————————
89 For example, in May 2000, a clearing member defaulted to
the New York Clearing Corporation. A significant contributing factor
was the lack of a rigorous settlement price procedure which allowed
prices in an illiquid market to be mismarked and unrealized losses
to accumulate. See Report on Lessons Learned from the Failure of
Klein & Co, Division of Trading and Markets, Commodity Futures
Trading Commission (July 2001).
—————————————————————————
The Commission believes that the proposed provisions avoid
potential miscalculations and would allow the variation margin
calculations to be monitored and, thereby, forestall potential problems
that could exacerbate a crisis. These measures are designed to be
prudent safeguards to be used to address weaknesses that may only
become apparent over time.
The Commission seeks comment on all aspects of the proposed
requirements for calculating variation margin.
The Commission requests comment on the costs and benefits of the
proposed approach. Commenters are urged to quantify the costs and
benefits, if practicable. Commenters also may suggest alternatives to
the proposed approach where the commenters believe that the
alternatives would be appropriate under the CEA.
G. Forms of Margin
1. Initial Margin
In general, the Commission believes that margin assets should share
the following fundamental characteristics. The assets should be liquid
and, with haircuts, hold their value in times of financial stress. The
value of the assets should not exhibit a significant correlation with
the creditworthiness of the counterparty or the value of the swap
portfolio.90
—————————————————————————
90 See BCBS/IOSCO Report at 16.
—————————————————————————
Guided by these principles, the Commission is proposing that CSEs
may only post or accept certain assets to meet initial margin
requirements to or from covered counterparties.91 These include: U.S.
dollars; cash in a currency in which payment obligations under the swap
are required to be settled; U.S. Treasury securities; certain
securities guaranteed by the U.S.; certain securities issued or
guaranteed by the European Central bank, a sovereign entity, or the
BIS; certain corporate debt securities; certain equity securities
contained in major indices; major currencies,92 and gold.
—————————————————————————
91 Proposed Regulation Sec. 23.156(a)(1).
92 Major currencies are defined in Proposed Regulation Sec.
23.151.
—————————————————————————
These are assets for which there are deep and liquid markets and,
therefore, assets that can be readily valued and easily liquidated.
This list includes a number of assets that were not included in the
2011 proposal. This is responsive to a number of commenters who
expressed concern about the narrowness of that list and the potential
that there would be insufficient available collateral.
The Commission notes that any debt security issued by a U.S.
Government-sponsored enterprise that is not operating with capital
support or another form of direct financial assistance from the U.S.
government
[[Page 59913]]
would be eligible collateral only if the security met the requirements
for corporate debt securities.
The Commission also notes that eligible collateral would include
other publicly-traded debt that has been deemed acceptable as initial
margin by a Prudential Regulator.93 The Prudential Regulators have
indicated that this would include securities that meet the terms of 12
CFR 1.2(d). That provision states that the issuer of a security must
have adequate capacity to meet financial commitments under the security
for the projected life of the asset or exposure. It further states an
issuer has adequate capacity to meet financial commitments if the risk
of default by the obligor is low and the full and timely payment of
principal and interest is expected. For example, municipal bonds that
meet this standard, as determined by a Prudential Regulator, would be
eligible collateral.
—————————————————————————
93 Proposed Regulation Sec. 23.156(a)(1)(ix).
—————————————————————————
Under the proposal, certain assets would be prohibited from use as
initial margin.94 These include any asset that is an obligation of
the party providing such asset or an affiliate of that party. These
also include instruments issued by bank holding companies, depository
institutions and market intermediaries. The use of such assets as
initial margin could compound risk. These restrictions reflect the
Commission’s view that the price and liquidity of securities issued by
the foregoing entities are very likely to come under significant
pressure during a period of financial stress when a CSE may be
resolving a counterparty’s defaulted swap position and present an
additional source of risk.
—————————————————————————
94 Proposed Regulation Sec. 23.156(a)(2).
—————————————————————————
The Commission requests comment on the securities subject to this
restriction, and, in particular, on whether securities issued by other
entities, such as non-bank systemically important financial
institutions designated by the Financial Stability Oversight Council,
also should be excluded from the list of eligible collateral.
Counterparties that wished to rely on assets that do not qualify as
eligible collateral under the proposed rule still would be able to
pledge those assets with a lender in a separate arrangement, such as
collateral transformation arrangements, using the cash or other
eligible collateral received from that separate arrangement to meet the
minimum margin requirements.
Moreover, the Commission notes that the proposal would not restrict
the types of collateral that could be collected or posted to satisfy
margin terms that are bilaterally negotiated above required amounts.
For example, if, notwithstanding the $65 million threshold, a CSE
decided to collect initial margin to protect itself against the credit
risk of a particular counterparty, the CSE could accept any form of
collateral.
Except for U.S. dollars and the currency in which the payment
obligations of the swap is required, assets posted as required initial
margin would be subject to haircuts in order to address the possibility
that the value of the collateral could decline during the period that
it took to liquidate a swap position in default. The proposed
collateral haircuts have been calibrated to be broadly consistent with
valuation changes observed during periods of financial stress.
Because the value of noncash collateral and foreign currency may
change over time, the proposal would require a CSE to monitor the value
of such collateral previously collected to satisfy initial margin
requirements and, to the extent the value of such collateral has
decreased, to collect additional collateral with a sufficient value to
ensure that all applicable initial margin requirements remain
satisfied.95
—————————————————————————
95 Proposed Regulation Sec. 23.156(a)(4).
—————————————————————————
The Commission seeks comment on all aspects of the proposed
requirements for eligible collateral for initial margin. In particular,
the Commission requests comments on whether the list should be expanded
or contracted in any way. If so, subject to what terms and conditions?
The Commission requests comment on the costs and benefits of the
proposed approach. Commenters are urged to quantify the costs and
benefits, if practicable. Commenters also may suggest alternatives to
the proposed approach where the commenters believe that the
alternatives would be appropriate under the CEA.
2. Variation Margin
The proposal would require that variation margin be paid in U.S.
dollars, or a currency in which payment obligations under the swap are
required to be settled.96 When determining the currency in which
payment obligations under the swap are required to be settled, a
covered swap entity must consider the entirety of the contractual
obligation. As an example, in cases where a number of swaps, each
potentially denominated in a different currency, are subject to a
single master agreement that requires all swap cash flows to be settled
in a single currency, such as the Euro, then that currency (Euro) may
be considered the currency in which payment obligations are required to
be settled.
—————————————————————————
96 Proposed Regulation Sec. 23.156(b).
—————————————————————————
The proposal is narrower than the 2011 proposal which also
permitted U.S. Treasury securities.97 This change is designed to
reinforce the concept that variation margin is paid and to reduce the
potential for disputes to arise over the value of assets being used to
meet this margin requirement. This proposed change is consistent with
regulatory and industry initiatives to improve standardization and
efficiency in the OTC derivatives market. For example, in June of 2013,
ISDA published the 2013 Standard Credit Support Annex (“SCSA”). The
SCSA provides for the sole use of cash as eligible collateral for
variation margin. The Commission supports this and other ongoing
regulatory and industry efforts at standardization that improve
operational efficiency and reduce the differences between the bilateral
and cleared OTC derivatives markets.
—————————————————————————
97 76 FR 23732 at 23747.
—————————————————————————
In this regard, the Commission notes that central counterparties
generally require that variation margin be paid in cash. U.S. law
applicable to cleared swaps is consistent with this practice. Section
5b(c)(2)(E) of the CEA requires derivatives clearing organizations to
“complete money settlements on a timely basis (but not less frequently
than once each business day).” CFTC Regulation 39.14(a)(1) defines
“settlement” as, among other things, “payment and receipt of
variation margin for futures, options, and swaps.” CFTC Regulation
39.14(b) requires that “except as otherwise provided by Commission
order, derivatives clearing organizations shall effect a settlement
with each clearing member at least once each business day.”
The Commission believes that this change from the 2011 proposal is
appropriate because it better reflects that counterparties to swap
transactions generally view variation margin payments as the daily
settlement of their exposure(s) to one another. Additionally, limiting
variation margin to cash should sharply reduce the potential for
disputes over the value of variation margin.
Under this proposed rule, the value of cash paid to satisfy
variation margin requirements is not subject to a haircut. Variation
margin payments reflect gains and losses on a swap transaction, and
payment or receipt of variation margin generally represents a transfer
of ownership. Therefore, haircuts are not a
[[Page 59914]]
necessary component of the regulatory requirements for cash variation
margin.
The proposal is stricter than international standards which do not
require that variation margin be in cash.98 It is the same as the
Prudential Regulators’ proposal.
—————————————————————————
98 BCBS/IOSCO Report at 14-15. The international standards do
not distinguish between initial margin and variation margin in
discussing eligible assets.
—————————————————————————
The Commission seeks comment on all aspects of the proposed
requirements for forms of variation margin.
The Commission requests comment on the costs and benefits of the
proposed approach. Commenters are urged to quantify the costs and
benefits, if practicable. Commenters also may suggest alternatives to
the proposed approach where the commenters believe that the
alternatives would be appropriate under the CEA.
H. Custodial Arrangements
The proposal sets forth requirements for the custodial arrangements
for initial margin posted for transactions between CSEs and covered
counterparties.99 Each CSE that posts initial margin with respect to
an uncleared swap would be mandated to require that all funds or other
property that it provided as initial margin be held by one or more
custodians that were not affiliates of the CSE or the counterparty.
Each CSE that collects initial margin with respect to an uncleared swap
would be mandated to require that such initial margin be held at one or
more custodians that were not affiliates of the CSE or the
counterparty.
—————————————————————————
99 Proposed Regulation Sec. 23.157.
—————————————————————————
Each CSE would be required to enter into custodial agreements
containing specified terms. These would include a prohibition on
rehypothecating the margin assets and standards for the substitution of
assets.
The proposed rules are consistent with international standards
except that international standards would allow rehypothecation under
certain circumstances.100 The proposal is the same as the Prudential
Regulators’ proposal. The Commission also notes that the European
Supervisory Authorities have proposed to prohibit rehypothecation.101
—————————————————————————
100 BCBS/IOSCO Report at 19-20.
101 See “Draft Regulatory Technical Standards on Risk-
mitigation Techniques for OTC-derivative Contracts Not Cleared by a
CCP under Article 11(15) of Regulation (EU) No. 648/2012,” pp. 11,
42-43 (April 14, 2014).
—————————————————————————
The proposed approach is grounded in several provisions of section
4s(e) of the CEA. First, section 4s(e)(3)(A)(i) mandates that margin
rules “help ensure the safety and soundness of [SDs] and [MSPs].”
Maintaining margin collateral at an independent custodian subject to
specified terms protects both parties to a transaction by preventing
assets from being lost or misused. In particular, a prohibition on
rehypothecation enhances safety by avoiding the possibility that a
margin asset will be lost because of the failure of a third party who
was not a party to the original transaction.
Second, section 4s(e)(3)(C) mandates that margin rules preserve
“the financial integrity of the markets trading swaps” and “the
stability of the United States financial system.” Maintaining margin
collateral at an independent custodian preserves financial integrity
and financial stability by preventing the same asset from supporting
multiple positions. If an SD could take collateral posted by a
counterparty for one swap and reuse it to margin a second swap with
another SD, and that SD could, in turn, do the same, this would
increase leverage in the system and create the possibility of a cascade
of defaults if one of these firms failed.
Third, section 4s(e)(3)(A) refers to the “greater risk” to SDs,
MSPs, and the financial system “arising from the use of swaps that are
not cleared.” It mandates rules “appropriate for the risk”
associated with uncleared swaps. Margin posted by customers to futures
commission merchants (“FCMs”) and by FCMs to DCOs for cleared swaps
is subject to segregation requirements.102 It would be inappropriate
to address the greater risk of uncleared swaps with a lesser standard.
—————————————————————————
102 Section 4d(f) of the CEA.
—————————————————————————
The proposed rules can be harmonized with section 4s(l) of the CEA
which authorizes counterparties of an SD or an MSP to request that
margin be segregated. As discussed above, covered counterparties pose
risk to the financial system. The primary purpose of the proposed
custodial arrangements is preservation of the financial integrity of
the markets and the U.S. financial system although the arrangements
will also have the effect of protecting individual market participants.
Section 4s(l) is not made superfluous by the proposed rules because it
would still be available for financial end users with less than
material swaps exposure, for financial end users that post initial
margin in excess of the required amount, and for non-financial end
users that post initial margin. Such entities would be posting margin,
by agreement, with SDs or MSPs. Section 4s(l) would provide them with
an opportunity to obtain additional protection if they desired.
The Commission previously adopted rules implementing section
4s(l).103 The Commission is now proposing to amend those rules to
reflect the approach described above where segregation of initial
margin would be mandatory under certain circumstances. The Commission
is proposing three changes.
—————————————————————————
103 Protection of Collateral of Counterparties to Uncleared
Swaps; Treatment of Securities in a Portfolio Margining Account in a
Commodity Broker Bankruptcy, 78 FR 66621 (Nov. 6, 2013).
—————————————————————————
First, the proposal would amend Sec. 23.701(a)(1) to read as
follows: Notify each counterparty to such transaction that the
counterparty has the right to require that any Initial Margin the
counterparty provides in connection with such transaction be segregated
in accordance with Sec. Sec. 23.702 and 23.703 except in those
circumstances where segregation is mandatory pursuant to Sec. 23.157.
(New language in italics.)
Second, the proposal would amend Sec. 23.701(d) to read as
follows: Prior to confirming the terms of any such swap, the swap
dealer or major swap participant shall obtain from the counterparty
confirmation of receipt by the person specified in paragraph (c) of
this section of the notification specified in paragraph (a) of this
section, and an election, if applicable, to require such segregation or
not. The swap dealer or major swap participant shall maintain such
confirmation and such election as business records pursuant to Sec.
1.31 of this chapter. (New language in italics.)
Third, the proposal would amend Sec. 23.701(f) to read as follows:
A counterparty’s election, if applicable, to require segregation of
Initial Margin or not to require such segregation, may be changed at
the discretion of the counterparty upon written notice delivered to the
swap dealer or major swap participant, which changed election shall be
applicable to all swaps entered into between the parties after such
delivery. (New language in italics.)
The Commission seeks comment on all aspects of the proposed
requirements regarding custodial arrangements.
The Commission requests comment on the costs and benefits of the
proposed approach. Commenters are urged to quantify the costs and
benefits, if practicable. Commenters also may suggest alternatives to
the proposed approach where the commenters believe that the
alternatives would be appropriate under the CEA.
I. Documentation
The proposal sets forth documentation requirements for CSEs.104
For uncleared swaps between a CSE and a covered counterparty, the
[[Page 59915]]
documentation would be required to provide the CSE with the contractual
right and obligation to exchange initial margin and variation margin in
such amounts, in such form, and under such circumstances as are
required by Sec. 23.150 through Sec. 23.160 of this part. For
uncleared swaps between a CSE and a non-financial entity, the
documentation would be required to specify whether initial and/or
variation margin will be exchanged and, if so, to include the
information set forth in the rule. That information would include the
methodology and data sources to be used to value positions and to
calculate initial margin and variation margin, dispute resolution
procedures, and any margin thresholds.
—————————————————————————
104 Proposed Regulation Sec. 23.158.
—————————————————————————
The international standards do not contain a specific requirement
for documentation. The requirements in the Prudential Regulators’
proposal are consistent with the Commission proposal but the Commission
proposal contains additional elements.
The Commission proposal contains a cross-reference to an existing
Commission rule which already imposes documentation requirements on SDs
and MSPs.105 Consistent with that rule, the proposal would apply
documentation requirements not only to covered counterparties but also
to non-financial end users. Having comprehensive documentation in
advance concerning these matters would allow each party to a swap to
manage its risks more effectively throughout the life of the swap and
to avoid disputes regarding issues such as valuation during times of
financial turmoil. This would benefit not only the CSE but the non-
financial end user as well.
—————————————————————————
105 Commission Regulation Sec. 23.504.
—————————————————————————
The Commission seeks comment on all aspects of the proposed
requirements for documentation.
The Commission requests comment on the costs and benefits of the
proposed approach. Commenters are urged to quantify the costs and
benefits, if practicable. Commenters also may suggest alternatives to
the proposed approach where the commenters believe that the
alternatives would be appropriate under the CEA.
J. Implementation Schedule
The proposed rules establish the following implementation schedule:
106
—————————————————————————
106 Proposed Regulation Sec. 23.160.
—————————————————————————
December 1, 2015 for the requirements in Sec. 23.153 for variation
margin;
December 1, 2015 for the requirements in Sec. 23.152 for initial
margin for any uncleared swaps where both (i) the CSE combined with all
its affiliates and (ii) its counterparty combined with all its
affiliates, have an average daily aggregate notional amount of
uncleared swaps, uncleared security-based swaps, foreign exchange
forwards, and foreign exchange swaps in June, July, and August 2015
that exceeds $4 trillion, where such amounts are calculated only for
business days;
December 1, 2016 for the requirements in Sec. 23.152 for initial
margin for any uncleared swaps where both (i) the CSE combined with all
its affiliates and (ii) its counterparty combined with all its
affiliates, have an average daily aggregate notional amount of
uncleared swaps, uncleared security-based swaps, foreign exchange
forwards, and foreign exchange swaps in June, July and August 2016 that
exceeds $3 trillion, where such amounts are calculated only for
business days;
December 1, 2017 for the requirements in Sec. 23.152 for initial
margin for any uncleared swaps where both (i) the CSE combined with all
its affiliates and (ii) its counterparty combined with all its
affiliates have an average daily aggregate notional amount of uncleared
swaps, uncleared security-based swaps, foreign exchange forwards, and
foreign exchange swaps in June, July and August 2017 that exceeds $2
trillion, where such amounts are calculated only for business days;
December 1, 2018 for the requirements in Sec. 23.152 for initial
margin for any uncleared swaps where both (i) the CSE combined with all
its affiliates and (ii) its counterparty combined with all its
affiliates have an average daily aggregate notional amount of uncleared
swaps, uncleared security-based swaps, foreign exchange forwards, and
foreign exchange swaps in June, July and August 2018 that exceeds $1
trillion, where such amounts are calculated only for business days;
December 1, 2019 for the requirements in Sec. 23.152 for initial
margin for any other CSE with respect to uncleared swaps entered into
with any other counterparty.
This extended schedule is designed to give market participants
ample time to develop the systems and procedures necessary to exchange
margin and to make arrangements to have sufficient assets available for
margin purposes. The requirements would be phased-in in steps from the
largest covered parties to the smallest.
Variation margin would be implemented on the first date for two
reasons. First, a significant part of the market currently pays
variation margin so full implementation would be less disruptive.
Second, the elimination of current exposures through the daily use of
variation margin would be an effective first step in enhancing the
safety and soundness of market participants and the financial integrity
of the markets.
The proposal is consistent with international standards except for
the 8 billion euro threshold, discussed above, that would apply
starting Dec. 1, 2019 under the international standards.107 The
proposal is the same as the proposal of the Prudential Regulators.
—————————————————————————
107 BCBS/IOSCO Report at 23-24.
—————————————————————————
The Commission requests comment on the costs and benefits of the
proposed approach. Commenters are urged to quantify the costs and
benefits, if practicable. Commenters also may suggest alternatives to
the proposed approach where the commenters believe that the
alternatives would be appropriate under the CEA.
K. Request for Comment
The Commission requests comment on all aspects of the proposed
rules. In particular, as noted above, the Commission invites comments
on the potential costs and benefits of each provision. Commenters are
urged to quantify the costs and benefits, if practicable. Commenters
also may suggest alternatives to the proposed approach where the
commenters believe that the alternatives would be appropriate under the
CEA.
III. Advance Notice of Proposed Rulemaking on the Cross-Border
Application of the Proposed Margin Rules
A. Alternative Options
Section 2(i) of the CEA 108 provides that the provisions of the
CEA relating to swaps that were enacted by the Wall Street Transparency
and Accountability Act of 2010 (including any rule prescribed or
regulation promulgated under that Act, shall not apply to activities
outside the United States unless those activities (1) have a direct and
significant connection with activities in, or effect on, commerce of
the United States or (2) contravene such rules or regulations as the
Commission may prescribe or promulgate as are necessary or appropriate
to prevent the evasion of any provision of this chapter that was
enacted by the Wall Street Transparency and Accountability Act of 2010.
—————————————————————————
108 7 U.S.C. 2(i).
—————————————————————————
Section 2(i) provides the Commission with express authority over
activities outside the United States relating to swaps when certain
conditions are met.
[[Page 59916]]
As discussed in part I.A. above, the primary purpose of the margin
provision in section 4s(e) is to address risk to SDs, MSPs, and the
financial system arising from uncleared swaps. Given the risk-
mitigation function of the margin rules for uncleared swaps, the
Commission believes that the rules should apply on a cross-border basis
in a manner that effectively addresses risks to the registered SD or
MSP. At the same time, it may be appropriate, consistent with
principles of international comity and statutory objectives underlying
the margin requirements, to allow SDs and MSPs to satisfy the margin
requirements by complying with a comparable regime in the relevant
foreign jurisdiction, or to not apply the margin requirements under
certain circumstances.
In this Advance Notice of Proposed Rulemaking, the Commission is
considering three approaches to applying the margin requirements to
Commission-registered SDs and MSPs, consistent with section 2(i): (1) A
transaction-level approach that is consistent with the Commission’s
cross-border guidance (“Guidance Approach”); 109 (2) the Prudential
Regulators’ approach; and (3) an entity-level approach (“Entity-Level
Approach”). The general framework for each of these approaches is
described below. The Commission is not endorsing at this time any
particular approach and invites comments on all aspects of the three
approaches and welcomes any suggestions on other possible approaches.
The Commission may propose and ultimately adopt one of the three
approaches with modifications.
—————————————————————————
109 Interpretative Guidance and Policy Statement Regarding
Compliance with Certain Swap Regulations, 78 FR 45292 (July 26,
2013) (“Guidance”). The Commission addressed, among other things,
how the swap provisions in the Dodd-Frank Act (including the margin
requirement for uncleared swaps) would apply on a cross-border
basis. In this regard, the Commission stated that as a general
policy matter it would apply the margin requirement as a
transaction-level requirement.
—————————————————————————
1. The Cross-Border Guidance Approach
Under the first option, the Commission would apply the margin
requirements consistent with the Cross-Border Guidance. The Commission
stated in the Guidance that it would generally treat the margin
requirements (for uncleared swaps) as a transaction-level requirement.
Consistent with the rationale stated in the Guidance, under this
approach, the proposed margin requirements would apply to a U.S. SD/MSP
(other than a foreign branch of a U.S. bank that is a SD/MSP) for all
of their uncleared swaps (as applicable), irrespective of whether the
counterparty is a U.S. person 110 or not, without substituted
compliance.
—————————————————————————
110 The scope of the term “U.S. person” as used in the
Cross-Border Guidance Approach and the Entity-Level Approach would
be the same as under the Guidance. See Guidance at 45316-45317 for a
summary of the Commission’s interpretation of the term “U.S.
person.”
—————————————————————————
On the other hand, under this approach, the proposed margin
requirements would apply to a non-U.S. SD/MSP (whether or not it is a
“guaranteed affiliate” 111 or an “affiliate conduit” 112) only
with respect to its uncleared swaps with a U.S. person counterparty
(including a foreign branch of U.S. bank that is a SD/MSP) and a non-
U.S. counterparty that is guaranteed by a U.S. person or is an
affiliate conduit. Where the counterparty is a guaranteed affiliate or
is an affiliate conduit, the Commission would allow substituted
compliance (i.e., the non-U.S. SD/MSP would be permitted to comply with
the margin requirements of its home country’s regulator if the
Commission determines that such requirements are comparable to the
Commission’s margin requirements).
—————————————————————————
111 Under the Guidance, id. at 45318, the term “guaranteed
affiliate” refers to a non-U.S. person that is an affiliate of a
U.S. person and that is guaranteed by a U.S. person. The scope of
the term “guarantee” under the Cross-Border Guidance Approach and
the Entity-Level Approach would be the same as under note 267 of the
Guidance and accompanying text.
112 Under the Guidance, id. at 45359, the factors that are
relevant to the consideration of whether a person is an “affiliate
conduit” include whether: (i) The non-U.S. person is majority-
owned, directly or indirectly, by a U.S. person; (ii) the non-U.S.
person controls, is controlled by, or is under common control with
the U.S. person; (iii) the non-U.S. person, in the regular course of
business, engages in swaps with non-U.S. third party(ies) for the
purpose of hedging or mitigating risks faced by, or to take
positions on behalf of, its U.S. affiliate(s), and enters into
offsetting swaps or other arrangements with such U.S. affiliate(s)
in order to transfer the risks and benefits of such swaps with
third-party(ies) to its U.S. affiliates; and (iv) the financial
results of the non-U.S. person are included in the consolidated
financial statements of the U.S. person. Other facts and
circumstances also may be relevant.
—————————————————————————
For trades between a non-U.S. SD/MSP (whether or not it is a
guaranteed affiliate or an affiliate conduit) and a non-U.S.
counterparty that is not a guaranteed affiliate or affiliate conduit,
the Commission would not apply the margin requirements to such swaps.
In the case of a foreign branch of a U.S. bank that is a SD/MSP,
the proposed margin requirements would apply with respect to all of its
uncleared swaps, regardless of the counterparty. However, where the
counterparty to the trade is another foreign branch of a U.S. bank that
is a SD/MSP or is a non-U.S. person counterparty (whether or not it is
a guaranteed affiliate or an affiliate conduit), the Commission would
allow substituted compliance (i.e., the foreign branch of a U.S. bank
that is a SD/MSP would be permitted to comply with the margin
requirements of the regulator in the foreign jurisdiction where the
foreign branch is located if the Commission determines that such
requirements are comparable to the Commission’s margin
requirements).113
—————————————————————————
113 Under a limited exception, where a swap between the
foreign branch of a U.S. SD/MSP and a non-U.S. person (that is not a
guaranteed or conduit affiliate) takes place in a foreign
jurisdiction other than Australia, Canada, the European Union, Hong
Kong, Japan, or Switzerland, the counterparties generally may comply
only with the transaction-level requirements in the foreign
jurisdiction where the foreign branch is located if the aggregate
notional value of all the swaps of the U.S. SD’s foreign branches in
such countries does not exceed 5% of the aggregate notional value of
all of the swaps of the U.S. SD, and the U.S. person maintains
records with supporting information for the 5% limit and can
identify, define, and address any significant risk that may arise
from the non-application of the Transaction-Level Requirements.
—————————————————————————
Below is a summary of how the margin requirements would apply under
the Cross-Border Guidance Approach.
—————————————————————————————————————-
U.S. person (other
than Foreign Foreign Branch of Non-U.S. person Non-U.S. person
Branch of U.S. U.S. Bank that is guaranteed by, or not guaranteed by,
Bank that is a a Swap Dealer or affiliate conduit and not an
Swap Dealer or MSP of, a U.S. person affiliate conduit
MSP) of, a U.S. person
—————————————————————————————————————-
U.S. Swap Dealer or MSP Apply…………. Apply…………. Apply…………. Apply
(including an affiliate of a
non-U.S. person).
Foreign Branch of U.S. Bank that Apply…………. Substituted Substituted Substituted
is a Swap Dealer or MSP. Compliance. Compliance. Compliance
Non-U.S. Swap Dealer or MSP Apply…………. Substituted Substituted Do Not Apply
(including an affiliate of a Compliance. Compliance.
U.S. person).
—————————————————————————————————————-
[[Page 59917]]
2. Prudential Regulators’ Approach
Under the second option, the Commission would adopt the Prudential
Regulators’ approach to cross-border application of the margin
requirements.114 Under the Prudential Regulators’ proposal, the
Prudential Regulators would not assert authority over trades between a
non-U.S. SD/MSP 115 that is not guaranteed by a U.S. person and
either a (i) non-U.S. SD/MSP that is not guaranteed by a U.S. person or
(ii) a non-U.S. person that is not guaranteed by a U.S. person. The
Prudential Regulators’ approach is generally consistent with the
Entity-Level Approach described below, with the exception of the
application of the margin requirements to certain non-U.S. SD/MSPs.
—————————————————————————
114 See Section 9 of Margin and Capital Requirements for
Covered Swap Entities, 12 CFR Part 237 (Sept. 3, 2014), available at
http://www.federalreserve.gov/newsevents/press/bcreg/bcreg20140903c1.pdf.
115 Under the Prudential Regulators’ approach, if an SD/MSP is
under the control of a U.S. person, it would not be considered a
non-U.S. SD/MSP.
—————————————————————————
However, the Prudential Regulators’ proposal in this regard would
be consistent with the Commission’s Cross-Border Guidance Approach to
margin requirements with respect to a trade between a non-U.S. SD/MSP
and a non-U.S. person that is not guaranteed by a U.S. person. But
under the definition of “foreign covered swap entity” in the
Prudential Regulators’ approach, a non-U.S. SD/MSP controlled by a U.S.
person would not be a foreign covered swap entity, and thus, would not
qualify for the exclusion from the margin requirement. In addition, the
Prudential Regulators’ proposal incorporates a “control” test for
purposes of determining whether a registered SD/MSP (or in the
Prudential Regulators’ proposal, a “covered swap entity”) is not a
“foreign” entity.
3. Entity-Level Approach
Under the third option, the Commission would treat the margin
requirements as an entity-level requirement. Under this Entity-Level
Approach, the Commission would apply its cross-border rules on margin
on a firm-wide level, irrespective of whether the counterparty is a
U.S. person.116 At the same time, in recognition of international
comity, the Commission is considering, where appropriate, to allow SDs/
MSPs to satisfy the margin requirements by complying with a comparable
regime in the relevant foreign jurisdiction, as described in the table
below. This approach would be intended to address the concern that the
source of the risk to a firm–given that the non-U.S. SD/MSP has
sufficient contact with the United States to require registration as an
SD/MSP–is not confined to its uncleared swaps with U.S. counterparties
or to its uncleared swaps executed within the United States. A firm’s
losses in uncleared swaps with non-U.S. counterparties, for example,
could have a direct and significant impact on the firm’s financial
integrity and on the U.S. financial system.
—————————————————————————
116 However, substituted compliance may be available under
certain circumstances, as described in the Guidance for entity-level
requirements.
————————————————————————
Applicable
Counterparty A Counterparty B requirements
————————————————————————
1. U.S. SD/MSP……………… U.S. person……. U.S. (All).
2. U.S. SD/MSP……………… Non U.S. person U.S. (All).
guaranteed by a
U.S. person.
3. Non-U.S. SD/MSP guaranteed by U.S. person not U.S. (All).
a U.S. person. registered as an
SD/MSP.
4. Non-U.S. SD/MSP guaranteed by Non-U.S. person U.S. (All).
a U.S. person. guaranteed by a
U.S. person.
5. U.S. SD/MSP……………… Non-U.S. person U.S. (Initial
not guaranteed by Margin collected
a U.S. person. by U.S. SD/MSP).
Substituted
Compliance
(Initial Margin
collected by non-
U.S. person not
guaranteed by a
U.S. person).
U.S. (Variation
Margin).
6. Non-U.S. SD/MSP guaranteed by Non-U.S. person U.S. (Initial
a U.S. person. not guaranteed by Margin collected
a U.S. person. by non-U.S. SD/
MSP guaranteed by
a U.S. person).
Substituted
Compliance
(Initial Margin
collected by non-
U.S. person not
guaranteed by a
U.S. person).
U.S. (Variation
Margin).
7. Non-U.S. SD/MSP not U.S. person not Substituted
guaranteed by a U.S. person. registered as an Compliance (All).
SD/MSP.
8 Non-U.S. SD/MSP not guaranteed Non-U.S. person Substituted
by a U.S. person. guaranteed by a Compliance (All).
U.S. person.
9. Non-U.S. SD/MSP not Non-U.S. SD/MSP Substituted
guaranteed by a U.S. person. not guaranteed by Compliance (All).
a U.S. person.
10. Non-U.S. SD/MSP not Non-U.S. person Substituted
guaranteed by a U.S. person. not registered as Compliance (All).
an SD/MSP and not
guaranteed by a
U.S. person.
————————————————————————
B. Questions
In this Advance Notice of Proposed Rulemaking, the Commission
requests comment on all aspects of these options to the cross-border
application of the margin requirements. In particular, the Commission
is interested in comments relating to the costs and benefits of the
various approaches so that it can take that into consideration when
developing proposed rules relating to the cross-border application of
the margin rules. Commenters are encouraged to address, among other
things, the following questions:
1. Under the Guidance Approach and Prudential Regulators Approach,
certain trades involving a non-U.S. SD/MSP would be excluded from the
Commission’s margin rules. The Commission seeks comment on whether this
exclusion is over- or under-inclusive, and if so, please explain why.
2. Each of the options provides for substituted compliance under
certain situations. In light of the equal or greater supervisory
interest of the foreign regulator in certain circumstances, the
Commission is seeking comment on whether the scope of substituted
compliance under each option is appropriate.
[[Page 59918]]
3. The Commission is seeking comments on whether, in defining a
non-U.S. covered swap entity, it should use the concept of “control,”
in determining whether a covered swap entity is (or should be treated
as) a non-U.S. covered swap entity. If the Commission uses a concept of
control, should it be the same as that used by the Prudential
Regulators, or should it be different?
4. In the Commission’s view, it is the substance, rather than the
form, of an agreement, arrangement or structure that should determine
whether it should be considered a “guarantee.” The Commission invites
comment on how the term “guarantee” should be construed or defined in
the context of these margin rules. For example, should the definition
cover the multitude of different agreements, arrangements and
structures that transfer risk directly back to the United States with
respect to financial obligations arising out of a swap? Should the
definition cover such agreements, arrangements and structures even if
they do not specifically reference the relevant swap or affirmatively
state that it does not apply to such swap? Should the definition cover
agreements, arrangements and structures even if the other party to the
swap terminates, waives, or revokes the benefit of such agreements,
arrangements or structures?
5. The Commission seeks comments on the costs and benefits of
harmonization with the Prudential Regulators’ proposal.
6. The Commission invites commenters to comment in particular on
the benefits of each of the approaches with respect to the statutory
goal of protecting the financial system against the risks associated
with uncleared swaps.
7. Given that some foreign jurisdictions may not adopt comparable
margin requirements, the Commission seeks comment on the costs and
benefits of not requiring substituted compliance in emerging markets
with respect to certain transactions and what might be an appropriate
threshold percentage of a swap portfolio of participants or other
standard for a de minimis level. In particular, the Commission is
seeking comment on potential competitive impacts. Commenters are
encouraged to quantify, if practical.
8. The Commission seeks comment, including quantitative estimates
in terms of notional volumes of swap activity, about how the different
cross-border alternatives may impact the competitive landscape between
U.S. entities and non-U.S. entities participating in swap markets.
Specifically, the Commission seeks quantitative estimates of costs of
transacting uncleared swaps with each category of counterparties, and/
or access specific geographical markets, under each of the different
alternatives. Commission seeks quantitative estimates of such impact on
the ability of the affected market participants (who might be unable to
access specific markets or counterparties) to hedge their risks using
uncleared swaps. As the proposed margins on uncleared swaps are
designed to strengthen market integrity, the Commission seeks comments
on potential impact of each of these alternatives on market
participants’ business models and trading strategies that could
potentially compromise this policy goal. Commenters are encouraged to
quantify and provide institutional details.
9. The Commission is seeking comments on how the different
alternatives impact price discovery? Commenters are encouraged to
quantify, if practical. For instance, will different cross-border
alternatives impact the ability of different categories of market
participants, as contemplated in these alternatives, to transact
uncleared swaps with each other? The Commission seeks quantitative
estimates of such impact on transacted volumes and the pricing of
uncleared swaps.
10. The Commission is seeking comments on the relative costs and
difficulty of compliance associated with each of the three approaches.
Is one of the approaches preferable to the others in this regard?
11. The Commission is seeking comments on the impact of each of the
three approaches on a SD/MSP’s risk management practices.
IV. Related Matters
A. Regulatory Flexibility Act
The Regulatory Flexibility Act (“RFA”) requires that agencies
consider whether the regulations they propose will have a significant
economic impact on a substantial number of small entities.117 The
Commission previously has established certain definitions of “small
entities” to be used in evaluating the impact of its regulations on
small entities in accordance with the RFA.118 The proposed
regulations would affect SDs and MSPs and their counterparties to
uncleared swaps. As the only counterparties of SDs and MSPs to
uncleared swaps can be other SDs, MSPs or ECPs, the following RFA will
only discuss these entities.
—————————————————————————
117 5 U.S.C. 601 et seq.
118 47 FR 18618 (Apr. 30, 1982).
—————————————————————————
The Commission previously has determined that SDs and MSPs are not
small entities for purposes of the RFA.119 The Commission also
previously has determined that ECPs are not small entities for RFA
purposes.120 Because ECPs are not small entities, and persons not
meeting the definition of ECP may not conduct transactions in uncleared
swaps, the Commission need not conduct a regulatory flexibility
analysis respecting the effect of these proposed rules on ECPs.
—————————————————————————
119 See 77 FR 30596, 30701 (May 23, 2012).
120 See 66 FR 20740, 20743 (April 25, 2001).
—————————————————————————
Accordingly, this proposed rule will not have a significant
economic effect on any small entity. Therefore, the Chairman, on behalf
of the Commission, hereby certifies pursuant to 5 U.S.C. 605(b) that
the proposed regulations will not have a significant economic impact on
a substantial number of small entities.
B. Paperwork Reduction Act
The Paperwork Reduction Act of 1995 (“PRA”) 121 imposes certain
requirements on Federal agencies, including the Commission, in
connection with their conducting or sponsoring any collection of
information, as defined by the PRA. This proposed rulemaking would
result in the collection of information requirements within the meaning
of the PRA, as discussed below. The proposed rulemaking contains
collections of information for which the Commission has previously
received control numbers from OMB. The titles for these collections of
information are “Regulations and Forms Pertaining to Financial
Integrity of the Market Place, OMB control number 3038-0024” and
“Swap Trading Relationship Documentation Requirements for Swap Dealers
and Major Swap Participants, OMB control number 3038-0088.”
—————————————————————————
121 44 U.S.C. 3501 et seq.
—————————————————————————
The collections of information that are proposed by this rulemaking
are necessary to implement section 4s(e) of the CEA, which expressly
requires the Commission to adopt rules governing margin requirements
for SDs and MSPs. If adopted, responses to this collection of
information would be mandatory. An agency may not conduct or sponsor,
and a person is not required to respond to, a collection of information
unless it displays a currently valid control number.
1. Clarification of Collection 3038-0088
This proposed rulemaking clarifies the existing collection of
information found in OMB Control Number 3038-
[[Page 59919]]
0088.122 Regulation 23.151 defines terms used in the proposed rule,
including the definition of “eligible master netting agreement,”
which provides that a CSE that relies on the agreement for purpose of
calculating the required margin must (1) conduct sufficient legal
review of the agreement to conclude with a well-founded basis that the
agreement meets specified criteria and (2) establish and maintain
written procedures for monitoring relevant changes in the law and to
ensure that the agreement continues to satisfy the requirements of this
section. The term “eligible master netting agreement” is used
elsewhere in the proposed rule to specify instances in which a CSE may
(1) calculate variation margin on an aggregate basis across multiple
non-cleared swaps and (2) calculate initial margin requirements under
an initial margin model for one or more swaps.
—————————————————————————
122 See OMB Control No. 3038-0088, available at http://www.reginfo.gov/public/do/PRAOMBHistory?ombControlNumber=3038-0088.
—————————————————————————
Proposed Regulations Sec. Sec. 23.152(c) and 23.153(d) specify
that a CSE shall not be deemed to have violated its obligation to
collect or post initial and variation margin, respectively, from or to
a counterparty if the CSE has made the necessary efforts to collect or
post the required margin, including the timely initiation and continued
pursuit of formal dispute resolution mechanisms, or has otherwise
demonstrated upon request to the satisfaction of the Commission that it
has made appropriate efforts to collect or post the required margin.
Proposed Regulation Sec. 23.154 establishes standards for initial
margin models. These standards include (1) a requirement that a CSE
review its initial margin model annually (Sec. 23.154(b)(4)); (2) a
requirement that the covered swap entity validate its initial margin
model initially and on an ongoing basis, describe to the Commission any
remedial actions being taken, and report internal audit findings
regarding the effectiveness of the initial margin model to the CSE’s
board of directors or a committee thereof (Sec. Sec. 23.154(b)(5)(ii)
through 23.154(b)(5)(iv)); (3) a requirement that the CSE adequately
documents all material aspects of its initial margin model (Sec.
23.154(b)(6)); and (4) a requirement that the CSE adequately documents
internal authorization procedures, including escalation procedures that
require review and approval of any change to the initial margin
calculation under the initial margin model, demonstrable analysis that
any basis for any such change is consistent with the requirements of
this section, and independent review of such demonstrable analysis and
approval (Sec. 23.154(b)(7)).
Proposed Regulation Sec. 23.155(b) requires a covered swap entity
to create and maintain documentation setting forth the variation margin
methodology, evaluate the reliability of its data sources at least
annually, and make adjustments, as appropriate, and provides that the
Commission at any time may require a covered swap entity to provide
further data or analysis concerning the methodology or a data source.
Proposed Regulation Sec. 23.158 requires a covered swap entity to
execute trading documentation with each counterparty that is either a
swap entity or financial end user regarding credit support arrangements
that (1) provides the contractual right to collect and post initial
margin and variation margin in such amounts, in such form, and under
such circumstances as are required; and (2) specifies the methods,
procedures, rules, and inputs for determining the value of each non-
cleared swap or non-cleared security-based swap for purposes of
calculating variation margin requirements, and the procedures for
resolving any disputes concerning valuation. The reporting and
recordkeeping requirements of proposed Regulation Sec. 23.158,
proposed Regulations Sec. 23.154(b)(4) through (7), and proposed
Regulation Sec. 23.155(b) are contained in the provisions of
Commission Regulations 23.500 through 23.506, which were adopted on
September 11, 2012, and part of OMB Control No. 3038-0088.123 Thus,
the requirements in this proposal that are subject to collection 3038-
0088 were previously addressed by the Commission in adopting the swap
documentation trading requirements and simply further clarified in this
proposal.
—————————————————————————
123 77 FR 55904 (Sept. 12, 2012).
—————————————————————————
To be sure, Commission Regulation Sec. 23.504(b) requires an SD or
MSP to maintain written swap trading relationship documentation that
must include all terms governing the trading relationship between the
SD or MSP and its counterparty, and Commission Regulation Sec.
23.504(d) requires that each SD and MSP maintain all documents required
to be created pursuant to Commission Regulation 23.504. Also,
Commission Regulation Sec. 23.502(c) requires each SD and MSP to
notify the Commission and any applicable Prudential Regulator of any
swap valuation dispute in excess of $20 million if not resolved in
specified timeframes. Accordingly, this proposed rulemaking,
specifically the requirements found in proposed Regulation Sec.
23.154(b)(4) through (7), proposed Regulations Sec. Sec. 23.155(b) and
23.158, would not impact the burden estimates currently provided for in
OMB Control No. 3038-0088.
2. Revisions to Collection 3038-0024
Collection 3038-0024 is currently in force with its control number
having been provided by OMB. The proposal would revise collection 3038-
0024 as discussed below.
Proposed Regulation Sec. 23.154(b)(1) requires CSEs that wish to
use initial margin models to obtain the Commission’s approval, and to
demonstrate to the Commission that the models satisfy standards
established in Sec. 23.154.124 These standards include (1) a
requirement that a CSE receive approval from the Commission based on a
demonstration that the initial margin model meets specific requirements
(Sec. 23.154(b)(1)); (2) a requirement that a CSE notify the
Commission in writing 60 days before extending the use of the model to
additional product types, making certain changes to the initial margin
model, or making material changes to modeling assumptions (Sec.
23.154(b)(1)); and (3) a variety of quantitative requirements,
including requirements that the CSE validate and demonstrate the
reasonableness of its process for modeling and measuring hedging
benefits, demonstrate to the satisfaction of the Commission that the
omission of any risk factor from the calculation of its initial margin
is appropriate, demonstrate to the satisfaction of the Commission that
incorporation of any proxy or approximation used to capture the risks
of the covered swap entity’s non-cleared swaps or non-cleared security-
based swaps is appropriate, periodically review and, as necessary,
revise the data used to calibrate the initial margin model to ensure
that the data incorporate an appropriate period of significant
financial stress (Sec. 23.154(b)(3)).
—————————————————————————
124 The Commission previously proposed to adopt regulations
governing standards and other requirements for initial margin models
that would be used by SDs and MSPs to margin uncleared swap
transactions. See Capital Requirements of Swap Dealers and Major
Swap Participants, 76 FR 27,802 (May 12, 2011). As part of the
proposal, the Commission submitted proposed revisions to collection
3038-0024 for the estimated burdens associated with the margin model
to OMB. The Commission is resubmitting new estimated burden as part
of this re-proposal of the regulations.
—————————————————————————
The requirement of proposed Regulation Sec. 23.154(b)(1) that a
CSE
[[Page 59920]]
must obtain the Commission’s approval to use an initial margin model by
submitting documentation demonstrating that the initial margin model
meets the standards set forth in Sec. 23.154, and the requirement that
a CSE must provide the Commission with written notice 60 days prior to
extending the use of the initial margin model to additional product
types or making material changes to the model would result in revisions
to the collection.
Currently, there are approximately 100 SDs and MSPs provisionally
registered with the Commission. The Commission further estimates that
approximately 60 of the SDs and MSPs will be subject to the
Commission’s margin rules as they are not subject to a Prudential
Regulator. The Commission further estimates that all SDs and MSPs will
seek to obtain Commission approval to use models for computing initial
margin requirements. The Commission estimates that the initial margin
model requirements will impose an average of 240 burden hours per
registrant.
Based upon the above, the estimated additional hour burden for
collection 3038-0024 was calculated as follows:
Number of registrants: 60.
Frequency of collection: Initial submission and periodic updates.
Estimated annual responses per registrant: 1.
Estimated aggregate number of annual responses: 60.
Estimated annual hour burden per registrant: 240 hours.
Estimated aggregate annual hour burden: 14,400 hours [60
registrants x 240 hours per registrant].
3. Information Collection Comments
The Commission invites the public and other Federal agencies to
comment on any aspect of the reporting burdens discussed above.
Pursuant to 44 U.S.C. 3506(c)(2)(B), the Commission solicits comments
in order to: (1) Evaluate whether the proposed collection of
information is necessary for the proper performance of the functions of
the Commission, including the information will have practical utility;
(2) evaluate the accuracy of the Commission’s estimate of the burden of
the proposed collection of information; (3) determine whether there are
ways to enhance the quality, utility, and clarity of the information to
be collected; and (4) minimize the burden of the collection of
information on those who are to respond, including through the use of
automated collection techniques or other forms of information
technology.
Comments may be submitted directly to the Office of Information and
Regulatory Affairs, by fax at (202) 395-6566 or by email at
[email protected]. Please provide the Commission with a copy
of submitted comments so that all comments can be summarized and
addressed in the final rule preamble. Refer to the ADDRESSES section of
this notice of proposed rulemaking for comment submission instructions
to the Commission. A copy of the supporting statements for the
collections of information discussed above may be obtained by visiting
RegInfo.gov. OMB is required to make a decision concerning the
collection of information between 30 and 60 days after publication of
this document in the Federal Register. Therefore, a comment is best
assured of having its full effect if OMB receives it within 30 days of
publication.
C. Cost-Benefit Considerations
1. Introduction
Section 15(a) of the CEA requires the Commission to consider the
costs and benefits of its actions before promulgating a regulation
under the CEA or issuing certain orders.125 Section 15(a) further
specifies that the costs and benefits shall be evaluated in light of
five broad areas of market and public concern: (1) Protection of market
participants and the public; (2) efficiency, competitiveness, and
financial integrity of futures markets; (3) price discovery; (4) sound
risk management practices; and (5) other public interest
considerations. The Commission considers the costs and benefits
resulting from its discretionary determinations with respect to the
section 15(a) factors.
—————————————————————————
125 7 U.S.C. 19(a).
—————————————————————————
The Commission recognizes that there is an inherent trade-off
involved in setting minimum collateral standards. Such standards could
increase margin requirements, which in turn would require market
participants to post additional collateral. Posting additional
collateral may result in opportunity costs in terms of lost returns
from investing the funds in collateral, or in interest expenses
incurred to raise additional funds. Such costs may reduce the
investment returns for market participants posting collateral. On the
other hand, minimum collateral standards help to mitigate counterparty
credit risk. This is achieved by requiring market participants to post
collateral that is sufficient to cover potential losses from default
most of the time. The potential reduction in investment returns for
market participants posting collateral might also be offset to some
degree by improvements in pricing as a result of the reduction in risk
of the swap. The reduction in counterparty credit risk from the posting
of collateral may result in tighter spreads quoted by liquidity
providers.126 From a regulatory perspective, minimum collateral
standards introduce a trade-off between potentially lowering
anticipated returns for market participants and lowering systemic risk
from counterparty defaults. A substantial loss from a default might
induce a cascade of defaults in a financial network, and perhaps,
induce a liquidity crisis and the seizing up of parts of the financial
system. In developing this proposal, the Commission has sought to
reduce the potential lowering of investment returns of market
participants by allowing them to use approved models to set margin
collateral for certain swap transactions while still guarding against
the dangers of systemic risk from counterparty defaults, along with
other parts of the rule.
—————————————————————————
126 Posting collateral for swap transactions may result in
other changes in the relationship between the CSE and counterparty
instead of just pricing terms of swap contracts. For instance, bank
CSEs might lower the required minimum balance on checking accounts
that counterparty maintain with the bank, instead.
—————————————————————————
2. Rule Summary
This proposed rulemaking is a re-proposal of prior CFTC proposed
rulemaking.127 It is the result of a working group consultation paper
issued by BCBS-IOSCO on margin for OTC-derivative contracts not cleared
by a CCP (uncleared derivatives).128 This proposed rulemaking would
implement the new statutory framework of section 4s(e) of the CEA,
added by section 731 of the Dodd-Frank Act, which requires the
Commission to adopt capital and initial and variation margin
requirements for certain SDs and MSPs. Generally, the proposed rule
would require the exchange (collection, posting, and payment) of margin
by SDs and MSPs for trades with other SDs, MSPs and financial end-
users. Initial margin is required to be held at third-party custodians
with no rehypothecation. These CSEs would not be required to collect
margin from or post margin to commercial end-users.
—————————————————————————
127 See 76 FR 23732 (April 28, 2011).
128 Margin requirements for non-centrally cleared derivatives
at http://www.bis.org/publ/bcbs261.pdf, September 2013. The proposed
rule establishes minimum standards for margin requirements for non-
centrally cleared derivatives as agreed by BIS and IOSCO.
—————————————————————————
Generally, the CFTC’s margin rules will apply to a SD or MSP
whenever
[[Page 59921]]
there is no Prudential Regulator for that covered swap entity.129 The
CFTC’s margin rules will apply to swaps that are not cleared and that
are executed subsequent to applicable compliance dates set out below,
based on an entity’s level of uncleared swaps activity during a
particular period.
—————————————————————————
129 For this rulemaking, a swap entity is either a swap dealer
or a major swap participant.
—————————————————————————
Generally, a CSE must collect IM from a counterparty that is (i) a
swap entity, or (ii) a financial end-user with material swaps exposure
($3 billion notional during June, July and August of the previous year)
in an amount that is no less than the greater of: (i) Zero (0) or (ii)
the IM collection amount for such swap less the IM threshold amount
($65 million–not including any portion of the IM threshold amount
already applied by the covered swap entity or its affiliates to other
swaps with the counterparty or its affiliates).
Generally, a CSE must post IM for any swap with a counterparty that
is a financial end-user with material swaps exposure (see above). A CSE
is not required to collect IM from or post IM to commercial end-users.
There are two general methods for calculating initial margin, the
standardized approach and the model-based approach. Under the
standardized approach, the CSE must calculate IM collection amounts
using a table/grid that is set out in the proposed rule.
The model-based approach calculates an amount of IM that is equal
to the potential future exposure (“PFE”) of a swap or a netting set
of swaps. PFE is an estimate of the one-tailed 99% confidence interval
for an increase in the value of the swap over a 10 day period (i.e.,
VaR model for a 10 day period). The model-based approach must meet the
following requirements: (1) The model must have prior written approval
by the Commission; (2) a CSE must demonstrate that the initial margin
model continuously satisfies the rule’s requirements; (3) a covered
swap entity must notify the Commission in writing prior to making
material changes to the model, such as: (a) Extending the use of the
model to an additional product type; (b) making any change that results
in material changes to the amount of IM; or (c) making any material
changes to the assumptions of the model. The Commission may rescind its
approval in whole or in part of an entity’s margin model at any time.
The rules for variation margin are as follows: (1) On or before the
business day after execution of an uncleared swap between a covered
swap entity and a counterparty that is a swap entity or a financial end
user, the covered swap entity must collect variation margin from or pay
variation margin to the counterparty; (2) a CSE is not required to
collect or pay variation from commercial end-users; and (3) a CSE is
not required to collect, post, or pay margin unless and until the total
amount of margin transfer to be collected or posted for an individual
counterparty exceeds the minimum transfer amount.
The eligible collateral for variation margin is cash funds
denominated in (a) USD, or (b) a currency in which payment under the
swap contracts is required. The eligible collateral for initial margin
includes (subject to haircuts on value) financial instruments in
various categories, including cash, Treasury securities, and various
publicly traded debt and equity instruments. A CSE may not collect or
post as initial margin any asset that is a security issued by (i) the
party providing such asset or an affiliate of that party; (ii) various
banking entities as listed in the proposed rule; or (iii) certain
government-sponsored enterprises unless an exception applies.
As defined in the rule, a financial end-user is any counterparty
that is not a covered swap entity and includes, among others: (i) A
commodity pool, commodity trading advisor and commodity pool operator
(all defined in the CEA); (ii) a private fund (defined in Investment
Advisers Act); (iii) an employee benefit plan, as defined in ERISA
section 3; (iv) a person predominantly engaged in activities that are
in the business of banking, or in activities that are financial in
nature (defined in section 4(k) of the BHCA); (v) a person defined in
(a)-(d), if that person organized under the laws of the U.S.; and (vi)
any other entity that in the Commission’s discretion is a financial
end-user. A non-financial end-user is any entity that is not a
financial end-user or an SD/MSP.
Generally, a CSE entering into a swap with a swap entity or a
financial end-user with material swap exposure who posts initial margin
to the counterparty must comply with the following conditions: (1) All
funds posted as initial margin must be held by a third-party custodian
(unaffiliated with either party in the swap); (2) the third-party
custodian is prohibited from re-hypothecating (or otherwise
transferring) the initial margin; (3) the third-party custodian is
prohibited from reinvesting the initial margin in any asset that would
not qualify as eligible collateral; and (4) the custodial agreement is
legal, valid, binding and enforceable in the event of bankruptcy,
insolvency, or similar proceedings.
Generally, a CSE entering into a swap with a swap entity or a
financial end-user with a material swap exposure that collects initial
margin from the counterparty must require the same conditions listed
above for initial margin posted.
Generally, CSEs must comply with the minimum margin requirements
for uncleared swaps on or before the following dates. For variation
margin, covered swap entities must comply by December 1, 2015. Initial
margin is subject to a phased-in period. The compliance date is
December 1, 2015 when both (i) the CSE and its affiliates and (ii) its
counterparty and its affiliates, have an average daily aggregate
notional amount of uncleared swaps, uncleared security-based swaps,
foreign exchange forwards and foreign exchange swaps for each business
day in June, July and August 2015 that exceeds $4 trillion. The
compliance date is December 1, 2016 when both (i) the CSE and its
affiliates and (ii) its counterparty and its affiliates, have an
average daily aggregate notional amount of uncleared swaps, uncleared
security-based swaps, foreign exchange forwards and foreign exchange
swaps for each business day in June, July and August 2016 that exceeds
$3 trillion. The compliance date is December 1, 2017 when both (i) the
CSE and its affiliates and (ii) its counterparty and its affiliates,
have an average daily aggregate notional amount of uncleared swaps,
uncleared security-based swaps, foreign exchange forwards and foreign
exchange swaps for each business day in June, July and August 2017 that
exceeds $2 trillion. The compliance date is December 1, 2018 when both
(i) the CSE and its affiliates and (ii) its counterparty and its
affiliates, have an average daily aggregate notional amount of
uncleared swaps, uncleared security-based swaps, foreign exchange
forwards and foreign exchange swaps for each business day in June, July
and August 2018 that exceeds $1 trillion. The compliance date is
December 1, 2019 for any other covered swap entity with respect to
uncleared swaps and uncleared security-based swaps entered into with
any other counterparty.
3. Status Quo Baseline
The baseline against which this proposed rule will be compared is
the status quo. This requires the Commission to assess what is the
current practice within the swaps industry. At present, swap market
participants are not legally required to post either initial or
variation margin
[[Page 59922]]
when engaging in uncleared swaps. Nevertheless, for risk management
purposes, many market participants currently undertake this practice.
In determining the current market practices, the Commission
utilized several sources of swaps market data. These sources include
(i) the ISDA Margin Survey 2014 (“ISDA Survey”), (ii) BIS’s
Quantitative impact study on margin requirements for non-centrally-
cleared OTC derivatives (“BCBS/IOSCO Quantitative Impact Study”), and
(iii) Swap Data Repository data (“SDR Data”). Although the data the
Commission is considering might not be complete, the Commission
requests comments regarding whether there is additional data that it
should consider when developing its baseline.
a. ISDA Margin Survey
A resource containing current market practice for uncleared swaps
is the ISDA Survey.130 The use of collateral agreements (those with
exposure and/or collateral balances) is substantial. The ISDA Survey
estimates that roughly 90% of all global uncleared OTC derivatives
trades have collateral agreements. 97% and 86% of global bilateral
transactions involving credit and fixed income, respectively, are
subject to collateral agreements or credit support annexes. The survey
reports that the use of cash and government securities accounts for
roughly 90% of uncleared global OTC derivative collateral, as has been
the case in prior years. The total global collateral related to
uncleared derivatives has decreased 14% from $3.7 trillion at the end
of 2012 to $3.2 trillion at the end of 2013. The survey asserts that
this decrease can be largely attributed to mandatory clearing
requirements.
—————————————————————————
130 See http://www2.isda.org/functional-areas/research/surveys/margin-surveys.
—————————————————————————
b. BCBS/IOSCO’s Quantitative Impact Study
Another source containing current market practices for uncleared
swaps is the BCBS/IOSCO Quantitative Impact Study.131 According to
the Study, BCBS/IOSCO Quantitative Impact Study respondents have
roughly [euro]319 trillion (approximately $415 trillion) in total
outstanding notional derivative positions, are collecting a total of
roughly [euro]95 billion (approximately $124 billion) in initial margin
and are posting roughly [euro]6 billion (approximately $7.8 billion) in
initial margin. Hence, average margin represents about 0.03% of the
gross notional exposure.” 132 The large difference between collected
and posted margin reflects the fact that the BCBS/IOSCO Quantitative
Impact Study respondents tend to be large derivative dealers with large
swap portfolios with transactions that on aggregate mostly offset, have
substantial capital, and who have high credit ratings, this generally
leads to lower margins.
—————————————————————————
131 Bank for International Settlements, February 2013, page
31, see http://www.bis.org/publ/bcbs242.pdf.
132 Bank for International Settlements, February 2013, page
31. See http://www.bis.org/publ/bcbs242.pdf.
—————————————————————————
In light of the definition of potential future exposure in this
proposal, it is useful to examine current practice. The table below,
reproduced from the BCBS/IOSCO Quantitative Impact Study provides some
statistics on potential future exposure, and related industry
practices.
Table 4b–Current Margin Practices for Uncleared Swaps
—————————————————————————————————————-
Number of
Average Median respondents
—————————————————————————————————————-
Margin period of risk (or risk horizon) in days…………….. 8.1 10.0 15
Confidence level (%) used………………………………… 96.2% 96.3% 14
Length of the look-back period (in years) used in calibration of 2.9 2.0 13
model………………………………………………….
Level of initial margin as a percentage of potential future 97.5% 100.0% 10
exposure……………………………………………….
Margin frequency (in days) Variation margin………………… 2.3 1.0 31
Initial margin………………………………………….. 1.0 1.0 21
—————————————————————————————————————-
Respondents have provided information on initial margin frequency. Eight (8) of these respondents collect
initial margin at deal inception. One (1) of them collects initial margin on an event-driven basis. The
remaining 12 respondents collect initial margin daily.
The Commission seeks comment on the representativeness of the BCBS/
IOSCO’s Quantitative Impact Study. How do the calculations in the BCBS/
IOSCO’s Quantitative Impact Study compare to the experience of
financial institutions? Commenters are encouraged to quantify when
possible.
c. Estimates Using SDR Data
Finally, the Commission reports aggregated data derived from data
submitted to swap data repositories in a weekly swaps market
report.133 Open swap positions in credit and interest rates as of
June 27, 2014 for CFTC regulated CSEs (59 entities) are presented
below. The table also includes total notional amount of swaps
transacted by these entities in credit and interest rates during the
period January to June 2014:
—————————————————————————
133 See http://www.cftc.gov/MarketReports/SwapsReports/index.htm.
Open Swaps as of June 27, 2014
[Notional amount in US$ billions (double count)]
————————————————————————
Uncleared Cleared
————————————————————————
Interest Rates…………………….. 253,434 223,744
Credit……………………………. 10,039 879
————————————————————————
[[Page 59923]]
Aggregate Notional Swaps Transaction (January to June 2014)
[Notional amount in US$ billions (double count)]
————————————————————————
Uncleared Cleared
————————————————————————
Interest Rates…………………….. 12,630 39,816
Credit……………………………. 1,362 5,717
————————————————————————
The Commission notes that OCC’s Economic Impact Analysis for Swaps
Margin Proposed Rule 134 has estimated that in year one, OCC-
supervised institutions will have to post total initial margin of
approximately $331 billion with approximately $283 billion in interest
rate and credit swaps. Using annualized notional swaps activity for
just interest rate and credit, and adopting a similar methodology to
the OCC’s Economic Impact Analysis, the Commission estimates that the
59 CFTC regulated CSEs will have to post initial margin in year one of
approximately $340 billion or possibly less as noted below. The OCC’s
estimate and the Commission’s estimate are not based on the same data.
The OCC’s estimates are based on transactions activity implied by the
open swaps positions from Call Report schedule RC-L. The Commission’s
estimates are based on transaction data reported to SDRs. To the extent
SDR data includes financial end users without material swaps exposure,
nonfinancial end users, sovereigns, and multilateral development banks
who do not have to post collateral, the amount of required initial
margin would be less than the Commission’s estimate of approximately
$340 billion. Further, the amount of required initial margin will be
lower as a result of the $65 million threshold, too. While the OCC has
made certain assumptions regarding coverage of the swaps activity by
its regulated entities during the different compliance dates, the
Commission does not have access to relevant data to make similar
estimates. The Commission’s initial margin estimates assume that
uncleared swaps activities by CFTC regulated CSEs in these two asset
classes will remain the same. These differences in approaches and the
data sources means that the Commission’s estimates will likely have
overstated the actual margins that will be posted in year one after
enactment.
—————————————————————————
134 See http://www.regulations.gov/#!documentDetail;D=OCC-
2011-0008-0131.
—————————————————————————
The Commission points out that prudentially regulated CSEs, CFTC
regulated CSEs, and SEC regulated CSEs will trade with each other.
Thus, one cannot simply add the margin estimates by various regulators
as this will double count the amount of initial margin collateral for
swap transactions between differently regulated CSEs. The Commission
seeks comment on how it should consider or allocate the common costs
and benefits of the margin collateral that is required by more than one
CSE regulator. Further, the Commission seeks comments on all aspects of
its initial margin estimates and methods. Commenters are encouraged to
quantify, if practical.
4. Section 15(a) Factors
a. Protection of Market Participants and the Public
Margin helps to protect market participants from counterparty
credit risk. It also helps to protect the public by lowering the
probability of a financial crisis, because margin helps to impede or
contain the risk of a cascade of defaults occurring. A cascade occurs
when one participant defaulting causes subsequent defaults by its
counterparties, and so on, resulting in a domino effect and a potential
financial crisis.
The derivatives positions of swap market participants are limited
by their ability to post margin. If the ability to post margin is
binding, then required margin may reduce swap market exposures for some
participants. In many cases, reduced swap market exposure for a
participant may lower their probability of default, all else equal.
Further, when a swap participant defaults, the margin can be used to
absorb the losses to the counterparty. This facilitates the non-
defaulting party reestablishing a similar position with a new
counterparty.
In requiring daily variation margin payments, the proposed rule
would require counterparties to mark-to-market all open swap positions.
The process of marking swap contracts to market or model, forces
participants to recognize losses promptly and to adjust collateral
accordingly. This helps to prevent the accumulation of large
unrecognized losses and exposures. Consequently, this frequent settling
up may reduce the probability of default of the party who has been
experiencing losses on the contract. The proposed rule however,
requires a minimum payment amount of $650,000, which provides
counterparties with operational relief. This minimum payment does not
lower the amount owed, but permits deferral of margin exchanges until
it is operationally efficient. In providing this relief the Commission
believes that it will lower the overall burden on the financial system,
but as a result of this amount being relatively small the Commission
believes this deferral would not noticeably increase the overall risk
to the financial system and the general public.
The proposed rule also provides that initial margin must be held at
a third-party custodian. The margin amount held there cannot be
rehypothecated with both parties having access to the collateral. This
access is designed to prevent a liquidity event, inducing a cascading
event. With rehypothecation, the collateral of some parties may be
linked or used as collateral posted for other positions–the same
collateral is posted for many positions for many different entities,
resulting in a rehypothecation chain. When a default or liquidity event
occurs at one link along the rehypothecation chain, it might induce
further defaults or liquidity events for other links in the
rehypothecation chain, because access to the collateral for other
positions may be obstructed by a default along the chain, which may
result in a liquidity event along the entire chain.
The cost of providing initial margin collateral reflects the cost
of obtaining the assets used as collateral, which is either the cost of
raising external funds, or the foregone income that could been earned
had the firm invested in a different asset (opportunity cost). The
effective cost is the difference between the relevant cost of obtaining
eligible assets and the return on the assets that can be pledged as
collateral. The effective cost will likely differ between entities and
even desks in the same entity as well as over time as conditions
change. At one extreme, it may be that some entities providing initial
margin, such as pension funds and asset managers, will provide assets
as initial margin that they already own and would have owned even if no
requirements were in place. In such cases the economic cost of
providing initial margin collateral is anticipated to be low. In other
cases, entities engaging
[[Page 59924]]
in uncleared swaps will have to raise additional funds to secure assets
that can be pledged as initial margin. The greater the costs of their
funding, relative to the rates of return on the initial margin
collateral, the greater the cost of providing collateral assets. It is
difficult, however, to estimate these costs due to differences in
funding costs across different types of entities as well as differences
in funding costs over time, and differences in the rate of return on
different collateral assets that may be used to satisfy the initial
margin requirements. In addition, as a result of the fact that posting
margin reduces the risk of default, the posting party could receive a
benefit in the form of improved pricing of the swap or other beneficial
changes to the relationship between the CSE and the counterparty. To
the extent any such benefit is realized, it would offset a portion of
the cost incurred in posting collateral.
The Commission seeks comment on the appropriate cost or a proxy for
the costs to posting collateral for CFTC regulated entities,
recognizing that CFTC entities may have different costs for pledging
collateral. The Commission also seeks comments on the quantitative
impact of these proposed rules on the pricing of swaps or other changes
in the relationships between CSEs and counterparties.
The proposal also requires that variation margin be exchanged
between covered swap entities and other swap entities and financial
end-users. The Commission preliminarily believes that the impact of
such requirements are low in the aggregate because: (i) regular
exchange of variation margin is already a well-established market
practice among a large number of market participants, and (ii) exchange
of variation margin simply redistributes resources from one entity to
another in a manner that imposes no aggregate liquidity costs. An
entity that suffers a reduction in liquidity from posting variation
margin is offset by an increase in the liquidity enjoyed by the entity
receiving the variation margin because variation margin is posted with
cash. The Commission notes that if the margin payments are not
instantaneous, however, there may be a slight loss in liquidity while
payments are being posted.
Posting margin may discourage some parties from hedging certain
risks because it is no longer cost effective for them to do so.
Consequently, this may reduce liquidity for some swap contracts. This
concern is mitigated somewhat by exempting non-financial end users from
having to post margin. Furthermore, not requiring parties to exchange
variation margin when the change in valuation is small enough,
$650,000, achieves additional cost savings. The proposed rule will
create additional demand for eligible collateral to post as margin.
Some advocates have expressed concern regarding the future availability
of eligible assets for market participants to post as margin; 135
however, in developing this proposal, the Commission has added
additional types of financial instruments to the list of eligible
collateral in an attempt to mitigate this concern. That being said, it
is too early to tell the extent to which eligible collateral will
become more expensive to obtain. Even if higher demand for collateral
does increase the price of certain existing assets, the Commission
surmises that markets for various forms of collateral will clear.
Higher prices may create incentives for creators of high quality assets
to supply more in the future. For instance, sovereigns and credit
worthy corporations may find it advantageous to issue more debt; as
demand increases for their debt, prices will rise with corresponding
borrowing rates decreasing. In addition, mutual funds and hedge funds
may be willing for a fee to lend out assets that they hold in their
portfolios to be pledged as initial margin. Some financial
intermediaries may set up services to transform other financial
instruments into eligible collateral, too.
—————————————————————————
135 See, for instances, Singh (2010), “Under-
collateralisation and rehypothecation in the OTC derivatives
markets,” Banque de France Financial Stability Review (14);
Sidanius and Zikes (2012), “OTC derivatives reform and collateral
demand impact,” Financial Stability Paper (18); and Duffie,
Scheicher, and Vuillemey (2014), “Central Clearing and Collateral
Demand,” working paper, Stanford University.
—————————————————————————
According to the Committee on the Global Financial System, there
seems to be sufficient eligible collateral at present and in the near
term, as they noted that “Current estimates suggest that the combined
impact of liquidity regulation and OTC derivatives reforms could
generate additional collateral demand to the tune of $4 trillion. At
the same time, the supply of collateral assets is known to have risen
significantly since end-2007. Outstanding amounts of AAA- and AA-rated
government securities alone–based on the market capitalization of
widely used benchmark indices–increased by $10.8 trillion between 2007
and 2012. Other measures suggest even greater increases in supply.”
136 As discussed above, there may be a reduction in the number of
swap contracts due to the cost of posting margin. Indeed, this may be
the case even if the cost of posting eligible collateral does not
increase in price. Finally, the proposed margin rules will be phased in
gradually. This gives regulators the ability to make adjustments, if
necessary.
—————————————————————————
136 Committee on the Global Financial System, “Asset
encumbrance and the demand for collateral assets”, CGFS Papers, no.
49, May 2013, http://www.bis.org/publ/cgfs49.pdf.
—————————————————————————
b. The Efficiency, Competitiveness, and Integrity of Markets
The proposed margin requirements make cleared swaps relatively more
attractive. The Commission is requiring ten day initial margins for
uncleared swaps and only five day margin for cleared swaps. In
addition, the Commission is only allowing limited netting for uncleared
swaps. All else equal, due to multilateral netting, less collateral may
be required in a cleared environment relative to an uncleared
environment.137
—————————————————————————
137 Anderson and Joeveer (2014), “The Economics of
Collateral,” working paper, London School of Economics.
—————————————————————————
The Commission is allowing only limited netting for uncleared
swaps. Limited netting may encourage participants to use a small number
of counterparties for multiple swap transactions, because participants
can only net swaps from those made with the same counterparty. This may
encourage the concentration of risk among a few counterparties.
However, these concerns may be mitigated somewhat by performing
frequent portfolio compression exercises that facilitate multilateral
netting.
Another cost of the rules may be a reduction in the efficacy of
hedging. Rules that make standardized swaps relatively less expensive
may induce some entities to forego some customized swaps that may
better match their exposures. However, before an entity decides to use
a standardized swap over a customized uncleared swap, it must weigh the
potentially lower margin costs from using standardized swaps against
potentially losses from imperfect hedges. Consequently, market
participants will still use customized swaps when they believe such
swaps are superior for their hedging needs.
All the market protection benefits discussed above may help to
improve the integrity of markets, because they make it more likely that
swap market participants will be able to perform on their contractual
obligations. This comes with potential losses to participants who have
to place their capital into margin and, hence potentially receive lower
anticipated returns on their capital.
[[Page 59925]]
The Commission has endeavored to harmonize this rulemaking with the
domestic prudential regulators, as well as with foreign regulators. Two
of the goals of harmonization are to satisfy the statute as well as to
create a more level playing field thereby promoting fairer competition
between entities regulated in different jurisdictions or by different
regulators. Otherwise, regulatory arbitrage opportunities might be
substantial. Price arbitrage occurs when an identical asset
simultaneously has two different prices, so that an arbitrager may buy
that asset where it is cheaper and sell it where it is more expensive
to garner a risk free profit. Similarly, a regulatory arbitrager takes
advantage of regulatory discrepancies by adapting activities so as to
locate them in jurisdictions to increase the arbitrager’s regulatory
profits (i.e., regulatory benefits minus regulatory burdens).
The Commission is in discussion with domestic and foreign
regulators on the material swap exposure threshold for financial end
users to be required to post margin collateral. The Commission notes
that some foreign regimes have proposed a higher threshold than $3
billion. In addition, the Commission realizes that setting a threshold
lower than another jurisdiction may result in some market participants
conducting some swaps in the jurisdiction with a lower threshold. The
Commission is required, to the maximum extent practicable, to harmonize
with prudential regulators, and domestic regulators are endeavoring to
harmonize with foreign regulators, as well. Therefore, the Commission
expects to consider the relative benefits that might come from having
consistent standards against those that might come from having
different thresholds. The Commission is seeking comment on the costs
and benefits of setting the threshold for material swap exposure for
financial end users to be required to post margin collateral at various
levels. In particular, commenters are encouraged to discuss competitive
impacts and to quantify, if practical. In addition, the Commission is
seeking comments on the costs and benefits of not fully harmonizing its
rules with those of the prudential regulators. Commenters are
encouraged to discuss the operational difficulties and to quantify, if
practical.
Inasmuch as larger banks tend to have a lower cost of capital than
smaller banks, the posting of margin for uncleared swaps may result in
a competitive advantage for larger banks when engaging in swaps, all
else equal. Even though they are exempted from clearing as financial
end users, small banks that have a material swaps exposure generally
will have to post margin collateral when engaging in uncleared swaps
with CFTC regulated CSEs. Thus, small banks may have to fund additional
collateral to post as margin for uncleared swaps or engage in more
cleared swaps that require relatively less collateral to post. The
Commission is seeking comment on the costs and benefits of requiring
small banks with material swaps exposures to post collateral with CFTC
regulated CSEs. Commenters may choose to recognize that under the
prudential regulators’ proposal, small banks that have a material swaps
exposure and that engage in swaps with prudentially regulated CSEs
would have to post margin collateral for uncleared swaps, too. Further,
commenters may also choose to recognize that the Commission is required
to harmonize this rulemaking, to the maximum extent practicable, with
the prudential regulators. Comments are encouraged to quantify, if
practical.
c. Price Discovery
The Commission is requiring ten day initial margins for uncleared
swaps and only five day margin for cleared swaps. In addition, the
Commission is only allowing limited netting for uncleared swaps.
Consequently, these rules promote the use of more standardized cleared
swaps at the expense of more customized and opaque swaps.
To the extent traders increase the use of standardized cleared
swaps in response to these rules, it may lead to greater transparency,
overall, in the swaps markets. Compared to uncleared swaps,
standardized swaps’ prices tend to be more transparent and the price
discovery process for such swaps may improve with higher volumes.
Conversely, lower volumes for uncleared swaps may negatively impact the
price discovery process for such swaps. However, the Commission
believes that the potential reduction in the efficacy of the price
discovery process for uncleared swaps is less of a concern, because the
price-setting process for uncleared swaps is not conducted on a
regulated platform or pursuant to rules requiring transparency and is
therefore relatively opaque in the current environment, anyway.
The Commission recognizes that another way the rules may affect
price discovery is by promoting confidence in the market. As such, the
margin collateral rules may protect, prophylactically, the price
discovery process of some swap contracts in some circumstances. The
rules might protect price discovery by reducing the frequency of
trading interruptions in segments of the swap market due to credit risk
concerns. This rulemaking might improve price discovery in these
instances, because the presence of collateral mitigates credit risk
concerns, and thereby allows these swap contract markets to remain
functioning. In turn, this permits market participants to continue to
observe the prices of these swaps.
The Commission requests comment on potential effects of the rule on
price discovery as well as on the relative use of cleared and uncleared
swaps, and on whether particular types of market participants,
including intermediaries such as regulated trading platforms, will be
impacted differently by the rule. Commenters are urged to quantify the
costs and benefits, if practicable.
d. Sound Risk Management Practices
Margin helps to mitigate the credit risk exposure resulting from
swap contracts. Further, it is a sound practice to regularly mark to
market or model to prevent the accumulation of unrecognized losses and
exposures (through the exchange of variation margin). At the same time,
requiring margin may help deter traders from taking advantage of the
inherent leverage in certain swap transactions.
The Commission is requiring ten day initial margins for uncleared
swaps and only five day initial margin for cleared swaps. Thus, the
rule may result in the use of more standardized cleared swaps at the
expense of more customized swaps which may be harder to evaluate and
risk manage; however, this may result in market participants using non-
optimal hedging techniques, as noted above, which may increase overall
risk at a firm.
Prohibiting rehypothecation at third-party custodians when both
parties have access to the collateral will be helpful in the time of
default. Otherwise, a liquidity event might occur that induces a
cascading event, in which the positions will be linked to other
positions and counterparties. The policy of not allowing
rehypothecation, however, requires that more collateral be available to
post as margin. As discussed above, this does not seem to be a serious
problem at present, but it might become one in the future. In addition,
to protect parties against the circumstance when pledged collateral
might be appropriated by the counterparty, margins must be held at
third parties. Facilitating the use of more customized models might
induce market participants to more thoroughly analyze the risks of
their swap transactions, and may lead to better risk
[[Page 59926]]
management practices overall. The Commission is allowing various
methods to model the amount of collateral required as initial margin
for uncleared swap transactions, including Commission-approved standard
models or more customized ones.
In this proposal, the Commission has added flexibility to what
constitutes eligible collateral, allowing participants in uncleared
swap transactions to `optimize’ their collateral inasmuch as they may
reduce their opportunity cost losses from pledging assets with lower
anticipated returns. This may result in market participants focusing on
improving their margin and risk management practices.
e. Other Public Interest Considerations
The Commission has not identified any other public interest
considerations.
List of Subjects
17 CFR Part 23
Swaps, Swap dealers, Major swap participants, Capital and margin
requirements.
17 CFR Part 140
Authority delegations (Government agencies), Organization and
functions (Government agencies).
For the reasons discussed in the preamble, the Commodity Futures
Trading Commission proposes to amend 17 CFR chapter I as set forth
below:
PART 23–SWAP DEALERS AND MAJOR SWAP PARTICIPANTS
0
1. The authority citation for part 23 continues to read as follows:
Authority: 7 U.S.C. 1a, 2, 6, 6a, 6b, 6b-1, 6c, 6p, 6r, 6s, 6t,
9, 9a, 12, 12a, 13b, 13c, 16a, 18, 19, 21.
0
2. Add subpart E to part 23 to read as follows:
Subpart E–Capital and Margin Requirements for Swap Dealers and
Major Swap Participants
Sec.
23.100-23.149 [Reserved]
23.150 Scope.
23.151 Definitions applicable to margin requirements.
23.152 Collection and posting of initial margin.
23.153 Collection and payment of variation margin.
23.154 Calculation of initial margin.
23.155 Calculation of variation margin.
23.156 Forms of margin.
23.157 Custodial arrangements.
23.158 Margin documentation.
23.159 Compliance dates.
23.160-23.199 [Reserved]
Sec. Sec. 23.100-23.149 [Reserved]
Sec. 23.150 Scope.
The margin requirements set forth in Sec. 23.150 through Sec.
23.159 shall apply to uncleared swaps, as defined in Sec. 23.151, that
are executed after the applicable compliance dates set forth in Sec.
23.159.
Sec. 23.151 Definitions applicable to margin requirements.
For the purposes of Sec. Sec. 23.150 through 23.159:
Affiliate means any company that controls, is controlled by, or is
under common control with another company.
Bank holding company has the meaning specified in section 2 of the
Bank Holding Company Act of 1956 (12 U.S.C. 1841).
Broker dealer means an entity registered with the Securities and
Exchange Commission under section 15 of the Securities Exchange Act of
1934 (15 U.S.C. 78o).
Control of another company means:
(1) Ownership, control, or power to vote 25 percent or more of a
class of voting securities of the company, directly or indirectly or
acting through one or more other persons;
(2) Ownership or control of 25 percent or more of the total equity
of the company, directly or indirectly or acting through one or more
other persons; or
(3) Control in any manner of the election of a majority of the
directors or trustees of the company.
Counterparty means the other party to a swap to which a covered
swap entity is a party.
Covered counterparty means a financial end user with material swaps
exposure, a swap dealer, or a major swap participant that enters into a
swap with a covered swap entity.
Covered swap entity means a swap dealer or major swap participant
for which there is no prudential regulator.
Cross-currency swap means a swap in which one party exchanges with
another party principal and interest rate payments in one currency for
principal and interest rate payments in another currency, and the
exchange of principal occurs upon the inception of the swap, with
reversal of the exchange of principal at a later date that is agreed
upon at the inception of the swap.
Data source means an entity and/or method from which or by which a
covered swap entity obtains prices for swaps or values for other inputs
used in a margin calculation.
Depository institution has the meaning specified in section 3(c) of
the Federal Deposit Insurance Act (12 U.S.C. 1813(c)).
Eligible collateral means collateral described in Sec. 23.157.
Eligible master netting agreement means a written, legally
enforceable agreement provided that:
(1) The agreement creates a single legal obligation for all
individual transactions covered by the agreement upon an event of
default, including upon an event of receivership, insolvency,
liquidation, or similar proceeding, of the counterparty;
(2) The agreement provides the covered swap entity the right to
accelerate, terminate, and close out on a net basis all transactions
under the agreement and to liquidate or set off collateral promptly
upon an event of default, including upon an event of receivership,
insolvency, liquidation, or similar proceeding, of the counterparty,
provided that, in any such case, any exercise of rights under the
agreement will not be stayed or avoided under applicable law in the
relevant jurisdictions, other than in receivership, conservatorship,
resolution under the Federal Deposit Insurance Act (12 U.S.C. 1811 et
seq.), Title II of the Dodd-Frank Act (12 U.S.C. 4617) or under any
similar insolvency law applicable to U.S. Government-sponsored
enterprises (12 U.S.C. 2183 and 2279cc);
(3) The agreement does not contain a walkaway clause (that is, a
provision that permits a non-defaulting counterparty to make a lower
payment than it otherwise would make under the agreement, or no payment
at all, to a defaulter or the estate of a defaulter, even if the
defaulter or the estate of the defaulter is a net creditor under the
agreement); and
(4) A covered swap entity that relies on the agreement for purposes
of calculating the margin required by this part:
(i) Conducts sufficient legal review (and maintains sufficient
written documentation of that legal review) to conclude with a well-
founded basis that:
(A) The agreement meets the requirements of paragraphs (1) through
(3) of this definition; and
(B) In the event of a legal challenge (including one resulting from
default or from receivership, insolvency, liquidation, or similar
proceeding) the relevant court and administrative authorities would
find the agreement to be legal, valid, binding, and enforceable under
the law of the relevant jurisdictions; and
(ii) Establishes and maintains written procedures to monitor
possible changes in relevant law and to ensure that the agreement
continues to satisfy the requirements of this definition.
Financial end user means
[[Page 59927]]
(1) A counterparty that is not a swap entity and that is:
(i) A bank holding company or an affiliate thereof; a savings and
loan holding company; or a nonbank financial institution supervised by
the Board of Governors of the Federal Reserve System under Title I of
the Dodd-Frank Act (12 U.S.C. 5323);
(ii) A depository institution; a foreign bank; a Federal credit
union or State credit union as defined in section 2 of the Federal
Credit Union Act (12 U.S.C. 1752(1) and (6)); an institution that
functions solely in a trust or fiduciary capacity as described in
section 2(c)(2)(D) of the Bank Holding Company Act (12 U.S.C.
1841(c)(2)(D)); an industrial loan company, an industrial bank, or
other similar institution described in section 2(c)(2)(H) of the Bank
Holding Company Act (12 U.S.C. 1841(c)(2)(H));
(iii) An entity that is state-licensed or registered as:
(A) A credit or lending entity, including a finance company; money
lender; installment lender; consumer lender or lending company;
mortgage lender, broker, or bank; motor vehicle title pledge lender;
payday or deferred deposit lender; premium finance company; commercial
finance or lending company; or commercial mortgage company; except
entities registered or licensed solely on account of financing the
entity’s direct sales of goods or services to customers;
(B) A money services business, including a check casher; money
transmitter; currency dealer or exchange; or money order or traveler’s
check issuer;
(iv) A regulated entity as defined in section 1303(20) of the
Federal Housing Enterprises Financial Safety and Soundness Act of 1992
(12 U.S.C. 4502(20)) and any entity for which the Federal Housing
Finance Agency or its successor is the primary federal regulator;
(v) Any institution chartered and regulated by the Farm Credit
Administration in accordance with the Farm Credit Act of 1971, as
amended, 12 U.S.C. 2001 et seq.;
(vi) A securities holding company; a broker or dealer; an
investment adviser as defined in section 202(a) of the Investment
Advisers Act of 1940 (15 U.S.C. 80b-2(a)); an investment company
registered with the Securities and Exchange Commission under the
Investment Company Act of 1940 (15 U.S.C. 80a-1 et seq.).
(vii) A private fund as defined in section 202(a) of the Investment
Advisers Act of 1940 (15 U.S.C. 80-b-2(a)); an entity that would be an
investment company under section 3 of the Investment Company Act of
1940 (15 U.S.C. 80a-3) but for section 3(c)(5)(C); or an entity that is
deemed not to be an investment company under section 3 of the
Investment Company Act of 1940 pursuant to Investment Company Act Rule
3a-7 of the Securities and Exchange Commission (17 CFR 270.3a-7);
(viii) A commodity pool, a commodity pool operator, a commodity
trading advisor, or a futures commission merchant;
(ix) An employee benefit plan as defined in paragraphs (3) and (32)
of section 3 of the Employee Retirement Income and Security Act of 1974
(29 U.S.C. 1002);
(x) An entity that is organized as an insurance company, primarily
engaged in writing insurance or reinsuring risks underwritten by
insurance companies, or is subject to supervision as such by a State
insurance regulator or foreign insurance regulator;
(xi) An entity that is, or holds itself out as being, an entity or
arrangement that raises money from investors primarily for the purpose
of investing in loans, securities, swaps, funds or other assets for
resale or other disposition or otherwise trading in loans, securities,
swaps, funds or other assets;
(xii) A person that would be a financial entity described in
paragraphs (1)(i)-(xi) of this definition if it were organized under
the laws of the United States or any State thereof; or
(xiii) Notwithstanding paragraph (2) of this definition, any other
entity that the Commission determines should be treated as a financial
end user.
(2) The term “financial end user” does not include any
counterparty that is:
(i) A sovereign entity;
(ii) A multilateral development bank;
(iii) The Bank for International Settlements;
(iv) An entity that is exempt from the definition of financial
entity pursuant to section 2(h)(7)(C)(iii) of the Act and implementing
regulations; or
(v) An affiliate that qualifies for the exemption from clearing
pursuant to section 2(h)(7)(D) of the Act.
Foreign bank has the meaning specified in section 1 of the
International Banking Act of 1978 (12 U.S.C. 3101).
Foreign exchange forward and foreign exchange swap mean any foreign
exchange forward, as that term is defined in section 1a(24) of the Act,
and foreign exchange swap, as that term is defined in section 1a(25) of
the Act.
Initial margin means collateral collected or posted to secure
potential future exposure under one or more uncleared swaps.
Initial margin threshold amount means an aggregate credit exposure
of $65 million resulting from all uncleared swaps and uncleared
security-based swaps between a covered swap entity and its affiliates,
and a covered counterparty and its affiliates.
Major currencies means
(1) United States Dollar (USD);
(2) Canadian Dollar (CAD);
(3) Euro (EUR);
(4) United Kingdom Pound (GBP);
(5) Japanese Yen (JPY);
(6) Swiss Franc (CHF);
(7) New Zealand Dollar (NZD);
(8) Australian Dollar (AUD);
(9) Swedish Kronor (SEK);
(10) Danish Kroner (DKK);
(11) Norwegian Krone (NOK); and
(12) Any other currency designated by the Commission.
Market intermediary means
(1) A securities holding company;
(2) A broker or dealer;
(3) A futures commission merchant;
(4) A swap dealer; or
(5) A security-based swap dealer.
Material swaps exposure for an entity means that the entity and its
affiliates have an average daily aggregate notional amount of uncleared
swaps, uncleared security-based swaps, foreign exchange forwards, and
foreign exchange swaps with all counterparties for June, July and
August of the previous calendar year that exceeds $3 billion, where
such amount is calculated only for business days.
Minimum transfer amount means an initial margin or variation margin
amount under which no actual transfer of funds is required. The minimum
transfer amount shall be $650,000 or such other amount as the
Commission may establish by order.
Multilateral development bank means
(1) The International Bank for Reconstruction and Development;
(2) The Multilateral Investment Guarantee Agency;
(3) The International Finance Corporation;
(4) The Inter-American Development Bank;
(5) The Asian Development Bank;
(6) The African Development Bank;
(7) The European Bank for Reconstruction and Development;
(8) The European Investment Bank;
(9) The European Investment Fund;
(10) The Nordic Investment Bank;
(11) The Caribbean Development Bank;
(12) The Islamic Development Bank;
(13) The Council of Europe Development Bank; and
(14) Any other entity that provides financing for national or
regional
[[Page 59928]]
development in which the U.S. government is a shareholder or
contributing member or which the Commission determines poses comparable
credit risk.
Non-financial end user means a counterparty that is not a swap
dealer, a major swap participant, or a financial end user.
Prudential regulator has the meaning specified in section 1a(39) of
the Act.
Savings and loan holding company has the meaning specified in
section 10(n) of the Home Owners’ Loan Act (12 U.S.C. 1467a(n)).
Securities holding company has the meaning specified in section 618
of the Dodd-Frank Act (12 U.S.C. 1850a).
Security-based swap has the meaning specified in section 3(a)(68)
of the Securities Exchange Act of 1934 (15 U.S.C. 78c(a)(68)).
Sovereign entity means a central government (including the U.S.
government) or an agency, department, ministry, or central bank of a
central government.
State means any State, commonwealth, territory, or possession of
the United States, the District of Columbia, the Commonwealth of Puerto
Rico, the Commonwealth of the Northern Mariana Islands, American Samoa,
Guam, or the United States Virgin Islands.
Subsidiary means a company that is controlled by another company.
Swap entity means a swap dealer or major swap participant.
Uncleared security-based swap means a security-based swap that is
not cleared by a clearing agency registered with the Securities and
Exchange Commission.
Uncleared swap means a swap that is not cleared by a registered
derivatives clearing organization, or by a clearing organization that
has received a no-action letter or other exemptive relief from the
Commission permitting it to clear certain swaps for U.S. persons
without being registered as a derivatives clearing organization.
U.S. Government-sponsored enterprise means an entity established or
chartered by the U.S. government to serve public purposes specified by
federal statute but whose debt obligations are not explicitly
guaranteed by the full faith and credit of the U.S. government.
Variation margin means a payment by a party to its counterparty to
meet an obligation under one or more swaps between the parties as a
result of a change in value of such obligations since the trade was
executed or the previous time such payment was made.
Sec. 23.152 Collection and posting of initial margin.
(a) Collection–(1) Initial obligation. On or before the business
day after execution of an uncleared swap between a covered swap entity
and a covered counterparty, the covered swap entity shall collect
initial margin from the covered counterparty in an amount equal to or
greater than an amount calculated pursuant to Sec. 23.154, in a form
that complies with Sec. 23.156, and pursuant to custodial arrangements
that comply with Sec. 23.157.
(2) Continuing obligation. The covered swap entity shall continue
to hold initial margin from the covered counterparty in an amount equal
to or greater than an amount calculated each business day pursuant to
Sec. 23.154, in a form that complies with Sec. 23.156, and pursuant
to custodial arrangements that comply with Sec. 23.157, until such
uncleared swap is terminated or expires.
(b) Posting–(1) Initial obligation. On or before the business day
after execution of an uncleared swap between a covered swap entity and
a covered counterparty that is a financial end user, the covered swap
entity shall post initial margin with the covered counterparty in an
amount equal to or greater than an amount calculated pursuant to Sec.
23.154, in a form that complies with Sec. 23.156, and pursuant to
custodial arrangements that comply with Sec. 23.157.
(2) Continuing obligation. The covered swap entity shall continue
to post initial margin with the covered counterparty in an amount equal
to or greater than an amount calculated each business day pursuant to
Sec. 23.154, in a form that complies with Sec. 23.156, and pursuant
to custodial arrangements that comply with Sec. 23.157, until such
uncleared swap is terminated or expires.
(c) Satisfaction of collection and posting requirements. A covered
swap entity shall not be deemed to have violated its obligation to
collect or to post initial margin from a covered counterparty if:
(1) The covered counterparty has refused or otherwise failed to
provide, or to accept, the required initial margin to, or from, the
covered swap entity; and
(2) The covered swap entity has:
(i) Made the necessary efforts to collect or to post the required
initial margin, including the timely initiation and continued pursuit
of formal dispute resolution mechanisms, including pursuant to Sec.
23.504(b)(4), if applicable, or has otherwise demonstrated upon request
to the satisfaction of the Commission that it has made appropriate
efforts to collect or to post the required initial margin; or
(ii) Commenced termination of the uncleared swap with the covered
counterparty promptly following the applicable cure period and
notification requirements.
Sec. 23.153 Collection and payment of variation margin.
(a) Initial obligation. On or before the business day after
execution of an uncleared swap between a covered swap entity and a
counterparty that is a swap entity or a financial end user, the covered
swap entity shall collect variation margin from, or pay variation
margin to, the counterparty as calculated pursuant to Sec. 23.155 and
in a form that complies with Sec. 23.156.
(b) Continuing obligation. The covered swap entity shall continue
to collect variation margin from, or to pay variation margin to, the
counterparty as calculated each business day pursuant to Sec. 23.155
and in a form that complies with Sec. 23.156 each business day until
such uncleared swap is terminated or expires.
(c) Netting. To the extent that more than one uncleared swap is
executed pursuant to an eligible master netting agreement between a
covered swap entity and a counterparty, a covered swap entity may
calculate and comply with the variation margin requirements of this
section on an aggregate basis with respect to all uncleared swaps
governed by such agreement. If the agreement covers uncleared swaps
entered into before the applicable compliance date set forth in Sec.
23.159, those swaps must be included in the aggregate for the purposes
of calculation and complying with the variation margin requirements of
this section.
(d) Satisfaction of collection and payment requirements. A covered
swap entity shall not be deemed to have violated its obligation to
collect or to pay variation margin from a counterparty if:
(1) The counterparty has refused or otherwise failed to provide or
to accept the required variation margin to or from the covered swap
entity; and
(2) The covered swap entity has:
(i) Made the necessary efforts to collect or to pay the required
variation margin, including the timely initiation and continued pursuit
of formal dispute resolution mechanisms, or has otherwise demonstrated
upon request to the satisfaction of the Commission that it has made
appropriate efforts to collect or to pay the required variation margin;
or
(ii) Commenced termination of the uncleared swap with the
counterparty promptly following the applicable cure period and
notification requirements.
[[Page 59929]]
Sec. 23.154 Calculation of initial margin.
(a) Means of calculation. (1) Each business day each covered swap
entity shall calculate an initial margin amount to be collected from
each covered counterparty using:
(i) A risk-based model that meets the requirements of paragraph (b)
of this section; or
(ii) The table-based method set forth in paragraph (c) of this
section.
(2) Each business day each covered swap entity shall calculate an
initial margin amount to be posted with each covered counterparty that
is a financial end user using:
(i) A risk-based model that meets the requirements of paragraph (b)
of this section; or
(ii) The table-based method set forth in paragraph (c) of this
section.
(3) Each covered swap entity may reduce the amounts calculated
pursuant to paragraphs (a)(1) and (2) of this section by the initial
margin threshold amount provided that the reduction does not include
any portion of the initial margin threshold amount already applied by
the covered swap entity or its affiliates in connection with other
uncleared swaps or uncleared security-based swaps with the counterparty
or its affiliates.
(4) The amounts calculated pursuant to paragraph (a)(3) of this
section shall not be less than zero.
(5) A covered swap entity shall not be required to collect or to
post an amount below the minimum transfer amount.
(6) For risk management purposes, each business day each covered
swap entity shall calculate a hypothetical initial margin requirement
for each swap for which the counterparty is a non-financial end user
that has material swaps exposure to the covered swap entity as if the
counterparty were a covered counterparty and compare that amount to any
initial margin required pursuant to the margin documentation.
(b) Risk-based Models–(1) Commission approval. (i) A covered swap
entity shall obtain the written approval of the Commission to use a
model to calculate the initial margin required in this part.
(ii) A covered swap entity shall demonstrate that the model
satisfies all of the requirements of this section on an ongoing basis.
(iii) A covered swap entity shall notify the Commission in writing
60 days prior to:
(A) Extending the use of an initial margin model that has been
approved to an additional product type;
(B) Making any change to any initial margin model that has been
approved that would result in a material change in the covered swap
entity’s assessment of initial margin requirements; or
(C) Making any material change to modeling assumptions used by the
initial margin model.
(iv) The Commission may rescind its approval of the use of any
initial margin model, in whole or in part, or may impose additional
conditions or requirements if the Commission determines, in its sole
discretion, that the model no longer complies with this section.
(2) Applicability to multiple swaps. To the extent that more than
one uncleared swap is executed pursuant to an eligible master netting
agreement between a covered swap entity and a covered counterparty, a
covered swap entity may use its initial margin model to calculate and
comply with the initial margin requirements on an aggregate basis with
respect to all uncleared swaps governed by such agreement. If the
agreement covers uncleared swaps entered into before the applicable
compliance date, those swaps must be included in the aggregate in the
initial margin model for the purposes of calculating and complying with
the initial margin requirements.
(3) Elements of the model. (i) The model shall calculate an amount
of initial margin that is equal to the potential future exposure of the
uncleared swap or netting set of uncleared swaps covered by an eligible
master netting agreement. Potential future exposure is an estimate of
the one-tailed 99 percent confidence interval for an increase in the
value of the uncleared swap or netting set of uncleared swaps due to an
instantaneous price shock that is equivalent to a movement in all
material underlying risk factors, including prices, rates, and spreads,
over a holding period equal to the shorter of ten business days or the
maturity of the swap.
(ii) All data used to calibrate the model shall be based on an
equally weighted historical observation period of at least one year and
not more than five years and must incorporate a period of significant
financial stress for each broad asset class that is appropriate to the
uncleared swaps to which the initial margin model is applied.
(iii) The model shall use risk factors sufficient to measure all
material price risks inherent in the transactions for which initial
margin is being calculated. The risk categories shall include, but
should not be limited to, foreign exchange or interest rate risk,
credit risk, equity risk, agricultural commodity risk, energy commodity
risk, metal commodity risk, and other commodity risk, as appropriate.
For material exposures in significant currencies and markets, modeling
techniques shall capture spread and basis risk and shall incorporate a
sufficient number of segments of the yield curve to capture differences
in volatility and imperfect correlation of rates along the yield curve.
(iv) In the case of an uncleared cross-currency swap, the model
need not recognize any risks or risk factors associated with the fixed,
physically-settled foreign exchange transactions associated with the
exchange of principal embedded in the cross-currency swap. The model
shall recognize all material risks and risk factors associated with all
other payments and cash flows that occur during the life of the
uncleared cross-currency swap.
(v) The model may calculate initial margin for an uncleared swap or
netting set of uncleared swaps covered by an eligible master netting
agreement. It may reflect offsetting exposures, diversification, and
other hedging benefits for uncleared swaps that are governed by the
same eligible master netting agreement by incorporating empirical
correlations within the following broad risk categories, provided the
covered swap entity validates and demonstrates the reasonableness of
its process for modeling and measuring hedging benefits: agriculture,
credit, energy, equity, foreign exchange/interest rate, metals, and
other. Empirical correlations under an eligible master netting
agreement may be recognized by the model within each broad risk
category, but not across broad risk categories.
(vi) If the model does not explicitly reflect offsetting exposures,
diversification, and hedging benefits between subsets of uncleared
swaps within a broad risk category, the covered swap entity shall
calculate an amount of initial margin separately for each subset of
uncleared swaps for which offsetting exposures, diversification, and
other hedging benefits are explicitly recognized by the model. The sum
of the initial margin amounts calculated for each subset of uncleared
swaps within a broad risk category shall be used to determine the
aggregate initial margin due from the counterparty for the portfolio of
uncleared swaps within the broad risk category.
(vii) The sum of the initial margins calculated for each broad risk
category shall be used to determine the aggregate initial margin due
from the counterparty.
[[Page 59930]]
(viii) The model shall not permit the calculation of any initial
margin amount to be offset by, or otherwise take into account, any
initial margin that may be owed or otherwise payable by the covered
swap entity to the counterparty.
(ix) The model shall include all material risks arising from the
nonlinear price characteristics of option positions or positions with
embedded optionality and the sensitivity of the market value of the
positions to changes in the volatility of the underlying rates, prices,
or other material risk factors.
(x) The covered swap entity shall not omit any risk factor from the
calculation of its initial margin that the covered swap entity uses in
its model unless it has first demonstrated to the satisfaction of the
Commission that such omission is appropriate.
(xi) The covered swap entity shall not incorporate any proxy or
approximation used to capture the risks of the covered swap entity’s
actual swaps unless it has first demonstrated to the satisfaction of
the Commission that such proxy or approximation is appropriate.
(xii) The covered swap entity shall have a rigorous and well-
defined process for re-estimating, re-evaluating, and updating its
internal models to ensure continued applicability and relevance.
(xiii) The covered swap entity shall review and, as necessary,
revise the data used to calibrate the model at least monthly, and more
frequently as market conditions warrant, ensuring that the data
incorporate a period of significant financial stress appropriate to the
uncleared swaps to which the model is applied.
(xiv) The level of sophistication of the initial margin model shall
be commensurate with the complexity of the swaps to which it is
applied. In calculating an initial margin amount, the model may make
use of any of the generally accepted approaches for modeling the risk
of a single instrument or portfolio of instruments.
(xv) The Commission may in its sole discretion require a covered
swap entity using a model to collect a greater amount of initial margin
than that determined by the covered swap entity’s model if the
Commission determines that the additional collateral is appropriate due
to the nature, structure, or characteristics of the covered swap
entity’s transactions or is commensurate with the risks associated with
the transaction.
(4) Periodic review. A covered swap entity shall periodically, but
no less frequently than annually, review its model in light of
developments in financial markets and modeling technologies, and
enhance the model as appropriate to ensure that it continues to meet
the requirements for approval in this section.
(5) Control, oversight, and validation mechanisms. (i) The covered
swap entity shall maintain a risk management unit in accordance with
Sec. 23.600(c)(4)(i) that is independent from the business trading
unit (as defined in Sec. 23.600).
(ii) The covered swap entity’s risk control unit shall validate its
model prior to implementation and on an ongoing basis. The covered swap
entity’s validation process shall be independent of the development,
implementation, and operation of the model, or the validation process
shall be subject to an independent review of its adequacy and
effectiveness. The validation process shall include:
(A) An evaluation of the conceptual soundness of (including
developmental evidence supporting) the model;
(B) An ongoing monitoring process that includes verification of
processes and benchmarking by comparing the covered swap entity’s model
outputs (estimation of initial margin) with relevant alternative
internal and external data sources or estimation techniques including
benchmarking against observable margin standards to ensure that the
initial margin is not less than what a derivatives clearing
organization would require for similar cleared transactions; and
(C) An outcomes analysis process that includes back testing the
model.
(iii) If the validation process reveals any material problems with
the model, the covered swap entity shall notify the Commission of the
problems, describe to the Commission any remedial actions being taken,
and adjust the model to insure an appropriately conservative amount of
required initial margin is being calculated.
(iv) In accordance with Sec. 23.600(e)(2), the covered swap entity
shall have an internal audit function independent of the business
trading unit and the risk management unit that at least annually
assesses the effectiveness of the controls supporting the model
measurement systems, including the activities of the business trading
units and risk control unit, compliance with policies and procedures,
and calculation of the covered swap entity’s initial margin
requirements under this part. At least annually, the internal audit
function shall report its findings to the covered swap entity’s
governing body, senior management, and chief compliance officer.
(6) Documentation. The covered swap entity shall adequately
document all material aspects of its model, including management and
valuation of uncleared swaps to which it applies, the control,
oversight, and validation of the model, any review processes and the
results of such processes.
(7) Escalation procedures. The covered swap entity must adequately
document authorization procedures, including escalation procedures that
require review and approval of any change to the initial margin
calculation under the model, demonstrable analysis that any basis for
any such change is consistent with the requirements of this section,
and independent review of such demonstrable analysis and approval.
(c) Table-based method. If a model meeting the standards set forth
in paragraph (b) of this section is not used, initial margin shall be
calculated in accordance with this paragraph.
(1) Standardized initial margin schedule.
————————————————————————
Initial margin
requirement (%
Asset class of notional
exposure)
————————————————————————
Credit: 0-2 year duration…………………………. 2
Credit: 2-5 year duration…………………………. 5
Credit: 5+ year duration………………………….. 10
Commodity……………………………………….. 15
Equity………………………………………….. 15
Foreign Exchange/Currency…………………………. 6
Cross Currency Swaps: 0-2 year duration…………….. 1
Cross Currency Swaps: 2-5 year duration…………….. 2
Cross currency Swaps: 5+ year duration……………… 4
Interest Rate: 0-2 year duration…………………… 1
Interest Rate: 2-5 year duration…………………… 2
Interest Rate: 5+ year duration……………………. 4
Other…………………………………………… 15
————————————————————————
(2) Net to gross ratio adjustment. (i) For multiple uncleared swaps
subject to an eligible master netting agreement, the initial margin
amount under the standardized table shall be computed according to this
paragraph.
(ii) Initial Margin = 0.4 x Gross Initial Margin + 0.6 x Net-to-
Gross Ratio x Gross Initial Margin, where
(A) Gross Initial Margin = the sum of the product of each uncleared
swap’s effective notional amount and the gross initial margin
requirement for all uncleared swaps subject to the eligible master
netting agreement;
(B) Net-to-Gross Ratio = the ratio of the net current replacement
cost to the gross current replacement cost;
(C) Gross Current Replacement cost = the sum of the replacement
cost for each uncleared swap subject to the eligible master netting
agreement for which the cost is positive; and
[[Page 59931]]
(D) Net Current Replacement Cost = the total replacement cost for
all uncleared swaps subject to the eligible master netting agreement.
Sec. 23.155 Calculation of variation margin.
(a) Means of calculation. (1) Each business day each covered swap
entity shall calculate variation margin for itself and for each
counterparty that is a swap entity or a financial end user using a
methodology and inputs that to the maximum extent practicable rely on
recently-executed transactions, valuations provided by independent
third parties, or other objective criteria.
(2) Each covered swap entity shall have in place alternative
methods for determining the value of an uncleared swap in the event of
the unavailability or other failure of any input required to value a
swap.
(3) For risk management purposes, each business day each covered
swap entity shall calculate a hypothetical variation margin requirement
for each swap for which the counterparty is a non-financial end user
that has material swaps exposure to the covered counterparty as if the
counterparty were a covered swap entity and compare that amount to any
variation margin required pursuant to the margin documentation.
(b) Control mechanisms. (1) Each covered swap entity shall create
and maintain documentation setting forth the variation methodology with
sufficient specificity to allow the counterparty, the Commission, and
any applicable prudential regulator to calculate a reasonable
approximation of the margin requirement independently.
(2) Each covered swap entity shall evaluate the reliability of its
data sources at least annually, and make adjustments, as appropriate.
(3) The Commission at any time may require a covered swap entity to
provide further data or analysis concerning the methodology or a data
source, including:
(i) An explanation of the manner in which the methodology meets the
requirements of this section;
(ii) A description of the mechanics of the methodology;
(iii) The theoretical basis of the methodology;
(iv) The empirical support for the methodology; and
(v) The empirical support for the assessment of the data sources.
Sec. 23.156 Forms of margin.
(a) Initial margin–(1) Eligible collateral. A covered swap entity
shall collect and post as initial margin for trades with a covered
counterparty only the following assets:
(i) U.S. dollars;
(ii) A major currency;
(iii) A currency in which payment obligations under the swap are
required to be settled;
(iv) A security that is issued by, or unconditionally guaranteed as
to the timely payment of principal and interest by, the U.S. Department
of Treasury;
(v) A security that is issued by, or unconditionally guaranteed as
to the timely payment of principal and interest by, a U.S. government
agency (other than the U.S. Department of Treasury) whose obligations
are fully guaranteed by the full faith and credit of the U.S.
government;
(vi) A publicly traded debt security issued by, or an asset-backed
security fully guaranteed as to the timely payment of principal and
interest by, a U.S. government-sponsored enterprise that is operating
with capital support or another form of direct financial assistance
received from the U.S. government that enables the repayments of the
government-sponsored enterprise’s eligible securities; or
(vii) A security that is issued by, or fully guaranteed as to the
payment of principal and interest by, the European Central Bank or a
sovereign entity that is assigned no higher than a 20 percent risk
weight under the capital rules applicable to swap dealers subject to
regulation by a prudential regulator;
(viii) A security that is issued by, or fully guaranteed as to the
payment of principal and interest by, the Bank for International
Settlements, the International Monetary Fund, or a multilateral
development bank;
(ix) Other publicly-traded debt that has been deemed acceptable as
initial margin by a prudential regulator; or
(x) A publicly traded common equity security that is included in:
(A) The Standard & Poor’s Composite 1500 Index or any other similar
index of liquid and readily marketable equity securities as determined
by the Commission; or
(B) An index that a covered swap entity’s supervisor in a foreign
jurisdiction recognizes for purposes of including publicly traded
common equity as initial margin under applicable regulatory policy, if
held in that foreign jurisdiction; or
(xi) Gold.
(2) Prohibition of certain assets. A covered swap entity may not
collect or post as initial margin any asset that is a security issued
by:
(i) The party providing such asset or an affiliate of that party,
(ii) A bank holding company, a savings and loan holding company, a
foreign bank, a depository institution, a market intermediary, a
company that would be any of the foregoing if it were organized under
the laws of the United States or any State, or an affiliate of any of
the foregoing institutions, or
(iii) A U.S. government-sponsored enterprise after the termination
of capital support or another form of direct financial assistance
received from the U.S. government that enables the repayments of the
government-sponsored enterprise’s eligible securities unless:
(A) The security meets the requirements of paragraph (a)(1)(iv) of
this section;
(B) The security meets the requirements of paragraph (a)(1)(vii) of
this section; or
(C) The security meets the requirements of paragraph (a)(1)(viii)
of this section.
(3) Haircuts. (i) Each covered swap entity shall apply haircuts to
any asset posted or received as initial margin under this section that
reflect the credit and liquidity characteristics of the asset.
(ii) At a minimum, each covered swap entity shall apply haircuts to
any asset posted or received as initial margin under this section in
accordance with the following table:
Standardized Haircut Schedule
————————————————————————
————————————————————————
Cash in same currency as swap obligation………………….. 0.0
Eligible government and related debt (e.g., central bank, 0.5
multilateral development bank, GSE securities identified in
paragraph (a)(1)(iv) of this section): Residual maturity less
than one-year………………………………………….
Eligible government and related debt (e.g., central bank, 2.0
multilateral development bank, GSE securities identified in
paragraph (a)(1)(iv) of this section): Residual maturity
between one and five years………………………………
Eligible government and related debt (e.g., central bank, 4.0
multilateral development bank, GSE securities identified in
paragraph (a)(1)(iv) of this section): Residual maturity
greater than five years…………………………………
Eligible corporate debt (including eligible GSE debt securities 1.0
not identified in paragraph (a)(1)(iv) of this section):
Residual maturity less than one-year……………………..
Eligible corporate debt (including eligible GSE debt securities 4.0
not identified in paragraph (a)(1)(iv) of this section):
Residual maturity between one and five years………………
Eligible corporate debt (including eligible GSE debt securities 8.0
not identified in paragraph (a)(1)(iv) of this section):
Residual maturity greater than five years…………………
Equities included in S&P 500 or related index……………… 15.0
[[Page 59932]]
Equities included in S&P 1500 Composite or related index but 25.0
not S&P 500 or related index…………………………….
Gold………………………………………………….. 15.0
Additional (additive) haircut on asset in which the currency of 8.0
the swap obligation differs from that of the collateral asset.
————————————————————————
(iii) The value of initial margin collateral that is calculated
according to the schedule in paragraph (a)(3)(ii) of this section will
be computed as follows: The value of initial margin collateral for any
collateral asset class will be computed as the product of the total
value of collateral in any asset class and one minus the applicable
haircut expressed in percentage terms. The total value of all initial
margin collateral is calculated as the sum of the value of each type of
collateral asset.
(4) Monitoring Obligation. A covered swap entity shall monitor the
market value and eligibility of all collateral collected and held to
satisfy initial margin required by this part. To the extent that the
market value of such collateral has declined, the covered swap entity
shall promptly collect such additional eligible collateral as is
necessary to bring itself into compliance with the margin requirements
of this part. To the extent that the collateral is no longer eligible,
the covered swap entity shall promptly obtain sufficient eligible
replacement collateral to comply with this part.
(5) Excess initial margin. A covered swap entity may collect
initial margin that is not required pursuant to this part in any form
of collateral.
(b) Variation margin–(1) Eligible assets. A covered swap entity
shall pay and collect as variation margin to or from a covered
counterparty only cash in the form of:
(i) U.S. dollars; or
(ii) A currency in which payment obligations under the swap are
required to be settled.
(2) Collection obligation. A covered swap entity shall not be
deemed to have violated its obligation under this paragraph to collect
variation margin if:
(i) The counterparty has refused or otherwise failed to provide the
variation margin to the covered swap entity; and
(ii) The covered swap entity:
(A) Has made the necessary efforts to collect the variation margin,
including the timely initiation and continued pursuit of formal dispute
resolution mechanisms, including Sec. 23.504(b), if applicable, or has
otherwise demonstrated upon request to the satisfaction of the
Commission that it has made appropriate efforts to collect the
variation margin; or
(B) Has commenced termination of the swap or security-based swap
with the counterparty.
Sec. 23.157 Custodial arrangements.
(a) Initial margin posted by covered swap entities. Each covered
swap entity that posts initial margin with respect to an uncleared swap
shall require that all funds or other property that the covered swap
entity provides as initial margin be held by one or more custodians
that are not affiliates of the covered swap entity or the counterparty.
(b) Initial margin collected by covered swap entities. Each covered
swap entity that collects initial margin required by Sec. 23.152 with
respect to an uncleared swap shall require that such initial margin be
held at one or more custodians that are not affiliates of the covered
swap entity or the counterparty.
(c) Custodial agreement. Each covered swap entity shall enter into
an agreement with each custodian that holds funds pursuant to
paragraphs (a) or (b) of this section that:
(1) Prohibits the custodian from rehypothecating, repledging,
reusing, or otherwise transferring (through securities lending,
repurchase agreement, reverse repurchase agreement or other means) the
funds or other property held by the custodian;
(2) Notwithstanding paragraph (c)(1) of this section, with respect
to collateral posted or collected pursuant to Sec. 23.152, requires
the posting party, when it substitutes or directs the reinvestment of
posted collateral held by the custodian:
(i) To substitute only funds or other property that are in a form
that meets the requirements of Sec. 23.156 and in an amount that meets
the requirements of Sec. 23.152, subject to applicable haircuts; and
(ii) To reinvest funds only in assets that are in a form that meets
the requirements of Sec. 23.156 and in an amount that meets the
requirements of Sec. 23.152, subject to applicable haircuts;
(3) Is legal, valid, binding, and enforceable under the laws of all
relevant jurisdictions including in the event of bankruptcy,
insolvency, or a similar proceeding.
Sec. 23.158 Margin documentation.
(a) General requirement. Each covered swap entity shall execute
documentation with each counterparty that complies with the
requirements of Sec. 23.504 and that complies with this section. For
uncleared swaps between a covered swap entity and a covered
counterparty, the documentation shall provide the covered swap entity
with the contractual right and obligation to exchange initial margin
and variation margin in such amounts, in such form, and under such
circumstances as are required by Sec. Sec. 23.150 through 23.159. For
uncleared swaps between a covered swap entity and a non-financial
entity, the documentation shall specify whether initial and/or
variation margin will be exchanged and, if so, the documentation shall
comply with paragraph (b) of this section.
(b) Contents of the documentation. The margin documentation shall
specify the following:
(1) The methodology and data sources to be used to value uncleared
swaps and collateral and to calculate initial margin for uncleared
swaps entered into between the covered swap entity and the
counterparty;
(2) The methodology and data sources to be used to value positions
and to calculate variation margin for uncleared swaps entered into
between the covered swap entity participant and the counterparty;
(3) The procedures by which any disputes concerning the valuation
of uncleared swaps, or the valuation of assets posted as initial margin
or paid as variation margin may be resolved;
(4) Any thresholds below which initial margin need not be posted by
the covered swap entity and/or the counterparty; and
(5) Any thresholds below which variation margin need not be paid by
the covered swap entity and/or the counterparty.
Sec. 23.159 Compliance dates.
(a) Covered swap entities must comply with the minimum margin
requirements for uncleared swaps on or before the following dates for
uncleared swaps entered into on or after the following dates:
(1) December 1, 2015 for the requirements in Sec. 23.153 for
variation margin.
(2) December 1, 2015 for the requirements in Sec. 23.152 for
initial margin for any uncleared swaps where both the covered swap
entity combined with all its affiliates and its counterparty combined
with all its affiliates, have an average daily aggregate notional
amount of uncleared swaps, uncleared security-based swaps, foreign
exchange forwards, and foreign exchange swaps in June, July, and August
2015 that exceeds $4 trillion, where such amounts are calculated only
for business days.
(3) December 1, 2016 for the requirements in Sec. 23.152 for
initial margin for any uncleared swaps where
[[Page 59933]]
both the covered swap entity combined with all its affiliates and its
counterparty combined with all its affiliates, have an average daily
aggregate notional amount of uncleared swaps, uncleared security-based
swaps, foreign exchange forwards, and foreign exchange swaps in June,
July and August 2016 that exceeds $3 trillion, where such amounts are
calculated only for business days.
(4) December 1, 2017 for the requirements in Sec. 23.152 for
initial margin for any uncleared swaps where both the covered swap
entity combined with all its affiliates and its counterparty combined
with all its affiliates have an average daily aggregate notional amount
of uncleared swaps, uncleared security-based swaps, foreign exchange
forwards, and foreign exchange swaps in June, July and August 2017 that
exceeds $2 trillion, where such amounts are calculated only for
business days.
(5) December 1, 2018 for the requirements in Sec. 23.152 for
initial margin for any uncleared swaps where both the covered swap
entity combined with all its affiliates and its counterparty combined
with all its affiliates have an average daily aggregate notional amount
of uncleared swaps, uncleared security-based swaps, foreign exchange
forwards, and foreign exchange swaps in June, July and August 2018 that
exceeds $1 trillion, where such amounts are calculated only for
business days.
(6) December 1, 2019 for the requirements in Sec. 23.152 for
initial margin for any other covered swap entity with respect to
uncleared swaps entered into with any other counterparty.
(b) Once a covered swap entity and its counterparty must comply
with the margin requirements for uncleared swaps based on the
compliance dates in paragraph (a) of this section, the covered swap
entity and its counterparty shall remain subject to the requirements of
this subpart.
Sec. Sec. 23.160-23.199 [Reserved]
0
3. In Sec. 23.701 revise paragraphs (a)(1), (d), and (f) to read as
follows:
Sec. 23.701 Notification of right to segregation.
(a) * * *
(1) Notify each counterparty to such transaction that the
counterparty has the right to require that any Initial Margin the
counterparty provides in connection with such transaction be segregated
in accordance with Sec. Sec. 23.702 and 23.703 except in those
circumstances where segregation is mandatory pursuant to Sec. 23.157;
* * * * *
(d) Prior to confirming the terms of any such swap, the swap dealer
or major swap participant shall obtain from the counterparty
confirmation of receipt by the person specified in paragraph (c) of
this section of the notification specified in paragraph (a) of this
section, and an election, if applicable, to require such segregation or
not. The swap dealer or major swap participant shall maintain such
confirmation and such election as business records pursuant to Sec.
1.31 of this chapter.
* * * * *
(f) A counterparty’s election, if applicable, to require
segregation of Initial Margin or not to require such segregation, may
be changed at the discretion of the counterparty upon written notice
delivered to the swap dealer or major swap participant, which changed
election shall be applicable to all swaps entered into between the
parties after such delivery.
PART 140–ORGANIZATION, FUNCTIONS, AND PROCEDURES OF THE COMMISSION
0
4. The authority citation for part 140 continues to read as follows:
Authority: 7 U.S.C. 2(a)(12), 12a, 13(c), 13(d), 13(e), and
16(b).
0
5. In Sec. 140.93, add paragraph (a)(6) to read as follows:
Sec. 140.93 Delegation of authority to the Director of the Division
of Swap Dealer and Intermediary Oversight.
(a) * * *
(6) All functions reserved to the Commission in Sec. Sec. 23.150
through 23.159 of this chapter.
* * * * *
Issued in Washington, DC, on September 23, 2014, by the
Commission.
Christopher J. Kirkpatrick,
Secretary of the Commission.
Note: The following appendices will not appear in the Code of
Federal Regulations.
Appendices to Margin Requirements for Uncleared Swaps for Swap Dealers
and Major Swap Participants–Commission Voting Summary, Chairman’s
Statement, and Commissioner’s Statement
Appendix 1–Commission Voting Summary
On this matter, Chairman Massad and Commissioners Wetjen, Bowen,
and Giancarlo voted in the affirmative. No Commissioner voted in the
negative.
Appendix 2–Statement of Chairman Timothy G. Massad
I support this proposed rule on margin requirements for uncleared
swaps.
A key mandate of the Dodd-Frank Act was central clearing of swaps.
This is a significant tool to monitor and mitigate risk, and we have
already succeeded in increasing the overall percentage of the market
that is cleared from an estimated 17% in 2007 to 60% last month, when
measured by notional amount.
But cleared swaps are only part of the market. Uncleared, bilateral
swap transactions will continue to be an important part of the
derivatives market. This is so for a variety of reasons. Sometimes,
commercial risks cannot be hedged sufficiently through clearable swap
contracts. Therefore market participants must craft more tailored
contracts that cannot be cleared. In addition, certain products may
lack sufficient liquidity to be centrally risk-managed and cleared.
This may be true even for products that have been in existence for some
time. And there will–and always should be–innovation in the market,
which will lead to new products.
That is why margin for uncleared swaps is important. It is a means
to mitigate the risk of default and therefore the potential risk to the
financial system as a whole. To appreciate the importance of the rule
being proposed, we need only recall how Treasury and the Federal
Reserve had to commit $182 billion to AIG, because its uncleared swap
activities threatened to bring down our financial system.
The proposed rule requires swap dealers and major swap participants
to post and collect margin in their swaps with one another. They must
also do so in their swaps with financial entities, if the level of
activity is above certain thresholds. The proposal does not require
commercial end-users to post or collect margin, nor does it require any
swap dealer or major swap participant to collect margin from or post
margin to commercial end-users. This is an important point.
Today’s proposal on margin also reflects the benefit of substantial
collaboration between our staff and our colleagues at the Federal
Reserve, the Office of the Comptroller of the Currency, and the Federal
Deposit Insurance Corporation, as well as significant public comment.
The Dodd-Frank Act directs each of the prudential regulators to propose
rules on margin for the entities for which it is the primary regulator,
whereas the CFTC is directed to propose a rule for other
[[Page 59934]]
entities engaging in uncleared swap transactions. The Dodd-Frank Act
also directed us to harmonize our rules as much as possible. Today’s
proposed rule is very similar to the proposal of the prudential
regulators that was published recently. I want to again thank our
staff, as well as the staffs of the prudential regulators, for working
together so well to accomplish that task.
We have also sought to harmonize our proposal with rules being
developed in Europe and Asia. Our proposed rule is largely consistent
with the standards proposed by Basel Committee on Banking Supervision
and the International Organization of Securities Commissions, and we
have been in touch with overseas regulators as we developed our
proposal.
The importance of international harmonization cannot be
understated. It is particularly important to reach harmonization in the
area of margin for uncleared swaps, because this is a new requirement
and we do not want to create the potential for regulatory arbitrage in
the market by creating unnecessary differences. Margin for uncleared
swaps goes hand in hand with the global mandates to clear swaps.
Imposing margin on uncleared swaps will level the playing field between
cleared and uncleared swaps and remove any incentive not to clear swaps
that can be cleared.
Proposing this rule is an important step in our effort to finish
the job of implementing the Dodd-Frank Act and will help us achieve the
full benefit of the new regulatory framework, while at the same time
protecting the interests of–and minimizing the burdens on–commercial
end-users who depend on the derivatives markets to hedge normal
business risks.
We recognize that more stringent margin requirements impose costs
on market participants, and therefore the proposal includes a detailed
cost-benefit analysis. I believe the proposed rule balances the
inherent trade-off between mitigating systemic risk and minimizing
costs on individual participants. I look forward to having public
feedback on that analysis, as well as on the proposal as a whole.
Appendix 3–Statement of Commissioner J. Christopher Giancarlo
I support the issuance of the proposed rules for uncleared
margin. I look forward to reviewing well-considered, responsive and
informative comments from the public. Seeking further public comment
on this proposal is necessary given the passage of time and the
further deliberations with our fellow regulators since the
publishing of our 2011 proposal. For the same reasons, I urge the
Commission to re-propose capital requirements for swap dealers and
major swap participants, which are closely linked to the uncleared
margin rules.
Uncleared over-the-counter swaps (OTC) and derivatives are vital
to the U.S. economy. Used properly, they enable American companies
and the banks they borrow from to manage changing commodity and
energy prices, fluctuating currency and interest rates, and credit
default exposure. They allow our state and local governments to
manage their obligations and our pension funds to support healthy
retirements. Uncleared swaps serve a key role in American business
planning and risk management that cannot be filled by cleared
derivatives. They do so by allowing businesses to avoid basis risk
and obtain hedge accounting treatment for more complex, non-
standardized exposures. While much of the swaps and OTC derivatives
markets will eventually be cleared–a transition I have long
supported–uncleared swaps will remain an important tool for
customized risk management by businesses, governments, asset
managers and other institutions whose operations are essential to
American economic growth.
Advance Notice of Proposed Rulemaking: Cross-Border
I support the Commission’s decision to issue an advance notice
of proposed rulemaking to determine how the uncleared margin rule
should apply extraterritorially. I have long advocated that the
Commission take a holistic, global approach to the cross-border
application of its rules. This approach should prioritize the
critical need for international harmony and certainty for American
businesses and other market participants. It is undeniable that the
lack of such certainty in the Commission’s cross-border framework is
causing fragmentation of what were once global markets, increasing
systemic risk rather than diminishing it. I therefore applaud the
Commission’s decision to seek public comment on the most optimal
cross-border framework with respect to uncleared margin.
In light of the recent decision from the U.S. District Court for
the District of Columbia holding that the Commission’s cross-border
guidance is non-binding and that the Commission will have to justify
the cross-border application of its rules each time it brings an
enforcement action,1 it is important that the Commission provide
swaps market participants with certainty on how the uncleared margin
rule will apply extraterritorially.
—————————————————————————
1 SIFMA v. CFTC, No. 13-cv-1916 slip op. at 72 (D.D.C. Sept.
16, 2014).
—————————————————————————
I believe that the advance notice of proposed rulemaking for the
cross-border application of the uncleared margin rules demonstrates
a pragmatism and flexibility that belies the oft repeated notion
that CFTC rulemaking widely and woodenly overreaches in its
assertion of extraterritorial jurisdiction. I commend it to our
fellow regulators abroad as a portent of greater accord in global
regulatory reform.
I look forward to reading and addressing well-considered
comments on the cross-border issues. In particular, I join
Commissioner Wetjen in welcoming thoughtful comment and analysis on
the potential competitive impacts associated with each of the
different approaches identified in the advance notice of proposed
rulemaking. I encourage commentators to quantify, if practical, and
be specific about particular provisions or concerns.
Furthermore, I think this rulemaking should be a template for
things to come. I urge the Commission to follow the Securities and
Exchange Commission’s (SEC) lead and replace its non-binding
guidance with a comprehensive set of rules, supported by a rigorous
cost-benefit analysis, delineating when activities outside the
United States will have a direct and significant connection with
activities in, or effect on, commerce in the United States. Good
regulation requires nothing less.
Notwithstanding my support for the issuance of these proposed
rules and the advance notice of proposed rulemaking on cross-border
issues in order to solicit comment, I have a number of substantive
concerns which I will now address.
Ten-Day Margin Requirement
Today’s proposal requires collateral coverage on uncleared swaps
equal to a ten-day liquidation period. This ten-day calculation
comports with rules adopted recently by the U.S. prudential bank
regulators. Yet, it still must be asked: Is ten days the right
calculation? Why not nine days; why not eleven? Should it be the
same ten days for uncleared credit default swaps as it is for
uncleared interest rate swaps and for all other swaps products?
Surely, all non-cleared swap products do not have the same liquidity
characteristics or risk profiles. I encourage commenters to provide
their input on these questions.
SEC Chair Mary Jo White recently stated: “Our regulatory
changes must be informed by clear-eyed, unbiased, and fact-based
assessments of the likely impacts–positive and negative–on market
quality for investors and issuers.” 2 Chair White’s standard of
assessment must surely apply to the proposed margin rule on
uncleared swaps. Where is the clear-eyed assessment of the ten-day
margin requirement? Where is the cost benefit analysis? What are the
intended consequences? What will be the unintended ones? Will
American swaps end users wind up paying for the added margin costs
even though they are meant to be exempt? I would be interested to
hear from commentators on this issue.
—————————————————————————
2 Phillip Stafford, Sense of Urgency Underpins Fresh Scrutiny
of Markets, Financial Times, Sept. 16, 2014, available at http://www.ft.com/intl/cms/s/0/a373646a-344b-11e4-b81c-00144feabdc0.html?siteedition=intl#axzz3DPM3AEzi.
—————————————————————————
I am troubled by recent press reports of remarks by unnamed Fed
officials that the coverage period may be intentionally “punitive”
in order to move the majority of trades into a cleared
environment.3 I would
[[Page 59935]]
be interested to review any considered analysis of the likely impact
of the ten-day liquidation period and whether or not it may have a
punitive effect on markets for uncleared swaps products.
—————————————————————————
3 Mike Kentz, Derivatives: Fed backs off corporate margin
requirements, IFRAsia, Sept. 11, 2014, available at http://www.ifrasia.com/derivatives-fed-backs-off-corporate-margin-requirements/21162697.fullarticle.
—————————————————————————
Any punitive or arbitrary squeeze on non-cleared swaps will
surely have consequences–likely unintended–for American businesses
and their ability to manage risk. With tens of millions of Americans
falling back on part-time work, it is not in our national interest
to deter U.S. employers from safely hedging commercial risk to free
capital for new ventures that create full-time jobs. It is time we
move away from punishing U.S. capital markets toward rules designed
to revive American prosperity. I look forward to reviewing well-
considered comments as to the appropriateness of a ten-day
liquidation period, as well as its estimated costs and benefits,
particularly the impact on American economic growth.
End Users
As noted in the preamble, the Dodd-Frank Act requires the CFTC,
the SEC, and the prudential regulators to establish comparable
initial and variation margin requirements for uncleared swaps.4 In
2011, however, the Commission and the prudential regulators issued
proposals that varied significantly in several respects. In
particular, the rules proposed by the prudential regulators in 2011
would have required non-financial end users to pay initial and
variation margin to banks, while the Commission’s rules exempted
these entities in accordance with Congressional intent.5
—————————————————————————
4 CEA section 4s(e)(3)(D)(ii).
5 Margin Requirements for Uncleared Swaps for Swap Dealers and
Major Swap Participants, 76 FR 23732, 23736-37 (Apr. 28, 2011).
—————————————————————————
I am pleased that the prudential regulators have moved in the
CFTC’s direction and will not require that non-financial end users
pay margin unless necessary to address the credit risk posed by the
counterparty and the risks of the swap.6 It is widely recognized
that non-financial end users, that generally use swaps to hedge
their commercial risk, pose less risk as counterparties than
financial entities. It is my hope that upon finalization of these
rules, swap dealers and major swap participants will treat non-
financial end users consistently when it comes to margin, no matter
which set of rules apply.
—————————————————————————
6 The prudential regulator’s proposal contains the following
provision: “A covered swap entity is not required to collect
initial margin with respect to any non-cleared swap or non-cleared
security-based swap with a counterparty that is neither a financial
end user with material swaps exposure nor a swap entity but shall
collect initial margin at such times and in such forms (if any) that
the covered swap entity determines appropriately address the credit
risk posed by the counterparty and the risks of such non-cleared
swaps and non-cleared security-based swaps.” Margin and Capital
Requirements for Covered Swap Entities, slip copy at 167, available
at http://www.federalreserve.gov/newsevents/press/bcreg/bcreg20140903c1.pdf. This is somewhat different, but not
inconsistent with the Commission’s proposal, which will allow the
parties to exchange margin by agreement, or to arrange other types
of collateral agreements consistent with their needs.
—————————————————————————
Threshold for Swaps Exposure
I am also pleased that our collaboration with the BCBS/IOSCO 7
international working group has resulted in proposed rules that are
largely harmonious with the 2013 international framework. There is a
particular and significant difference that troubles me, however. The
CFTC and the prudential regulators have set the threshold for
material swaps exposure by financial end users at $3 billion, while
the 2013 international framework sets the threshold at [euro]8
billion (approximately $11 billion). This means that a whole middle-
tier of American financial end users could be subject to margin
requirements that will not be borne by similar firms overseas. It
may well limit the number of counterparties willing to enter into
swaps with these important lenders to American business. I am
concerned that this could potentially reduce the utility of risk
reducing strategies for a class of middle-tier, U.S. financial
institutions that have already been hit hard by new capital
constraints, among other rules.
—————————————————————————
7 Basel Committee on Banking Supervision/International
Organization of Securities Commissions.
—————————————————————————
In this time of dismal economic growth, it is hard to justify
placing higher burdens on America’s medium-sized financial firms
than those their overseas competitors face. We have not, in my
opinion, sufficiently addressed in our cost benefit analysis the
impact of this threshold difference on American firms and their
customers. Where is the clear-eyed analysis of the impact of this
rule on the American economy? I hope that the Commission will not
perpetuate this divergence in the final rules without carefully
weighing the costs and benefits. I encourage commenters to address
this point and to supply any data and analysis that may be
illuminating. It is time our rules were designed less to punish and
more to promote U.S. capital markets. Punishment as a singular
regulatory policy is getting old and counterproductive. It is time
our rules focused on returning America to work and prosperity.
Increase Reliance on International Collaboration
Similarly, I want to echo Commissioner Wetjen’s call for
comments on two areas where the Commission can harness international
collaboration. First, I welcome comments on whether the Commission
should exclude from the scope of this rulemaking any derivative
cleared by a central counterparty (CCP) that is subject to
regulation and supervision consistent with the CPSS-IOSCO Principles
for Financial Market Infrastructures (PFMIs), an alternative on
which the Commission seeks comment in the preamble. It is reported
that at least one U.S. financial firm is a member at 70 different
CCPs around the globe. The present proposal, if finalized, could
result in trades cleared on many of these CCPs being treated as if
they are uncleared.8 This would seem to be a needlessly costly and
burdensome imposition on American commerce. Global regulators have
already agreed on international standards in the PFMIs to determine
how CCPs should be regulated and supervised. It makes sense to
leverage these standards where we can. I encourage comment on this
issue.
—————————————————————————
8 Sam Fleming and Phillip Stafford, JPMorgan Tells Clearers to
Build Bigger Buffers, Financial Times, Sept. 11, 2014 available at
http://www.ft.com/intl/cms/s/0/48aa6b02-38f9-11e4-9526-00144feabdc0.html#axzz3DPM3AEzi.
—————————————————————————
I would also be interested in commenters’ views on how the
Commission should conduct its comparability analysis under this
rulemaking. In the advance notice of proposed rulemaking, the
Commission proposes to permit market participants to comply with
foreign rules, if such rules are comparable to the Commission’s
margin requirements. Yet, a better approach may be to compare a
foreign regime to the international standards put forward by the
BCBS/IOSCO international working group that included participation
from over 20 regulatory authorities. Doing so would give the
Commission some comfort that foreign rules meet a necessary
baseline, but could avoid unnecessary and potentially destabilizing
disputes over comparability in the future. I hope the insights of
interested parties will guide not only the Commission, but also the
prudential regulators. I further hope all concerned parties can use
this rulemaking as an opportunity to promote international comity at
a time when it is sorely needed.
Treatment of Small Financial Entities
Another aspect of the proposed rules that concerns me is the
treatment of financial entities that qualify for the small bank
exemption from clearing and financial cooperatives. Section
2(h)(7)(C)(ii) of the CEA directed the Commission to consider
whether to exempt from the definition of “financial entity” small
banks, savings associations, farm credit system institutions and
credit unions with total assets of $10 billion or less. In response,
the Commission exempted these small financial institutions from the
definition of financial entity for purposes of clearing. It
recognized that these institutions serve a crucial function in the
markets for hedging the commercial risk of non-financial end users.
Moreover, the Commission acknowledged that the costs associated with
clearing, including margin and other fees and expenses, may be
prohibitive relative to the small number of swaps these firms
execute over a given period of time.9 In addition, using its
Section 4(c) exemptive authority, the Commission permits cooperative
financial entities, including those with total assets exceeding $10
billion, to elect an exemption from mandatory clearing for swaps
executed in connection with originating loans for their members, or
that hedge or mitigate commercial risk related to loans or swaps
with their members.10
—————————————————————————
9 End-User Exception to the Clearing Requirement for Swaps, 77
FR 42560, 42578 (Jul. 19, 2012); 17 CFR 50.50(d).
10 Clearing Exemption for Certain Swaps Entered into by
Cooperatives, 78 FR 52286 (Aug. 22, 2013); 17 CFR 50.51.
—————————————————————————
Despite the CFTC’s otherwise appropriate treatment of these
small banks and financial cooperatives, the proposed margin rules
treat them as financial institutions required to post
[[Page 59936]]
margin when their swaps exposure exceeds the $3 billion threshold.
This means that small banks and cooperative financial institutions
entitled to a clearing exemption will have to pay margin for their
uncleared activity with swap dealers or major swap participants when
they have material swaps exposure. It makes no sense to provide
these entities with an exemption from clearing on the one hand, only
to turn around and require them to bear the potentially even greater
costs associated with uncleared swaps. They deserve the full benefit
of their clearing exemption, which they may not get if they have to
post margin. I encourage comment on this issue, which I will weigh
carefully in the process of considering a final rule.
Inter-Affiliate Exemption
The proposed rules may also diminish the utility of the
critically important, inter-affiliate clearing exemption the
Commission adopted last year for certain eligible affiliate
counterparties.11 The exemption was premised on recognition that
transactions between affiliates do not present the same risks as
market-facing swaps, and generally provide risk-mitigating, hedging,
and netting benefits within a corporate group.12 I welcome
comments addressing the impact the proposed rules may have on the
ability of affiliated entities to efficiently manage their risk.13
—————————————————————————
11 Clearing Exemption for Swaps Between Certain Affiliated
Entities, 78 FR 21750 (Apr. 11, 2013); 17 CFR 50.52.
12 Id. at 21751-54.
13 Separately, I also welcome comments on the sufficiency of
the no-action relief issued by the Division of Clearing and Risk for
swaps entered into by treasury affiliates, and whether it may serve
as a model for future rulemaking to provide greater certainty in
this area. See CFTC Letter No. 13-22 (Jun. 4, 2013).
—————————————————————————
Use of Approved Models to Calculate Capital
Finally, I believe it is important to allow the use of models
when calculating initial margin. The proposed rules require the
Commission’s prior written approval before a model can be used, even
though the Commission lacks adequate staff and expertise for
evaluating models. We recognize in the preamble that many covered
swap entities are affiliates of entities whose margin models are
reviewed by one of the prudential regulators, the SEC, or a foreign
regulator, and to avoid duplicative efforts we plan to coordinate
with other regulators in an effort to expedite our review. Rather
than go through a special approval process, however, I believe we
should accept models approved by our fellow regulators, so long as
they contain the required elements. Alternatively, as mentioned in
the preamble and discussed at the open meeting, this may be an area
in which the National Futures Association can provide assistance,
and I am interested in hearing its views on the issue. I also join
Commissioner Wetjen’s call for discussion on the circumstances in
which the Commission may permit market participants to continue
using models while Commission staff is reviewing them. Given the
CFTC’s limited resources, I believe we should make every effort to
leverage the expertise of other qualified regulators before asking
for more tax dollars from Americans working two jobs just to stay
afloat.
Conclusion
In spite of my stated concerns, I support the issuance of these
proposed rules in order to solicit comment. They raise a number of
important issues, particularly in their impact on the U.S. economy
and job creation and the extent of their application across the
globe. It is vital that we hear from interested parties on how to
get them right. I commend the Chairman and my fellow Commissioners
for their thoughtfulness and open-mindedness in arriving at the
final proposals. I look forward to receiving and reviewing comments
on the issues discussed above and all aspects of the rules.
[FR Doc. 2014-22962 Filed 10-2-14; 8:45 am]
BILLING CODE 6351-01-P
Last Updated: October 3, 2014
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