Prudential Regulators Propose "Grab Bag" of Relief from Non-Cleared Swap Margin Rules
The Situation: The primary federal banking regulators have proposed wide-ranging changes to their non-cleared swap margin rules.
The Result: The proposed rules would (i) permit legacy swaps to be amended for LIBOR transition purposes without falling subject to margin requirements, (ii) push out the deadline for Phase Five initial margin compliance; and (iii) provide initial margin relief for swaps between affiliates.
Looking Ahead: The proposed rules are open for comment until 30 days after publication in the Federal Register (which should occur in the coming weeks). The Commodity Futures Trading Commission ("CFTC"), which has previously granted some of this relief through regulations and no action letters, and the Securities and Exchange Commission ("SEC"), which just recently published its margin regulations, are expected largely to follow suit.
As part of the Dodd-Frank derivatives markets reforms, the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System ("Federal Reserve"), the Federal Deposit Insurance Corporation ("FDIC"), the Farm Credit Administration, and the Federal Housing Finance Agency (collectively, "Prudential Regulators"), were charged with promulgating uniform regulations covering initial and variation margin on non-cleared swaps and security-based swaps transacted by "swap entities" within their supervisory jurisdiction. The resulting regulations ("PR Margin Rules") generally require swap dealers, major swap participants, security-based swap dealers, and security-based swap participants (collectively, "swap entities") who are regulated by a Prudential Regulator to post and collect variation and initial margin on their non-cleared swaps and security-based swaps (collectively, "swaps") with other swap entities and financial end-users. However, swaps entered into prior to the compliance dates set forth in the PR Margin Rules' implementation schedule ("Implementation Schedule") are "grandfathered" and not subject to the PR Margin Rules.
The Prudential Regulators approved and released for public comment a breathtakingly diverse set of proposed amendments ("Proposed Rules") to the PR Margin Rules on October 28, 2019 (the FDIC announced the proposals on September 17, 2019). The Proposed Rules address issues such as LIBOR transition, the Implementation Schedule for initial margin and the treatment of interaffiliate swaps. Comments are due within 30 days of the publication of the Proposed Rules in the Federal Register.
This Commentary introduces the Proposed Rules and compares them with the current swap margin rules of the CFTC and the SEC.
LIBOR Cessation and Other "Safe Harbored" Amendments
An amendment or novation of a legacy swap that was previously grandfathered and not subject to the PR Margin Rules will generally cause that swap to become subject to the potentially onerous margin requirements of the PR Margin Rules. The Prudential Regulators, however, have been known to make exceptions in order to encourage certain important industry initiatives. For example, amendments entered into solely to comply with QFC rules or on account of Brexit will not trigger loss of grandfathered status.
Industry efforts to safeguard against the expected demise of LIBOR fit squarely in this category. Lack of clear direction from the Prudential Regulators on this matter would have represented a significant disincentive for market participants to adhere to the proposed "protocol" for amending "legacy" LIBOR swaps to reference new "fallback" rates upon LIBOR cessation. As such, the Proposed Rules would preserve "legacy" status for swaps that are amended "solely to accommodate" the replacement of LIBOR, other "at risk" interbank offered rates and any rate that has succeeded those rates. The "safe harbor" would also cover ancillary amendments concerning spread adjustments, calculation periods, and payment dates, so long as the "effective notional amount" and tenor are not increased. We expect that similar moves to foster LIBOR transition from the CFTC and SEC are only a matter of time.
The Proposed Rules also seek to establish a number of other "safe harbors" for amendments that will avoid loss of "legacy" swap status. These include amendments that are: (i) purely non-economic amendments (e.g., reflecting address and name changes and other purely operational or administrative matters), (ii) reductions in notional value arising from partial terminations or partial novations (for the surviving portion of the legacy swap); and (iii) certain amendments and "new" swaps executed in the course of "portfolio compression" exercises that reduce operational or counterparty risks by netting down multiple swaps. The Proposed Rules relating to partial terminations and novations and portfolio compression are consistent with prior "no action" relief in the mandatory clearing context from the CFTC.
"Phase Five" Initial Margin
In accordance with the Implementation Schedule all industry participants are already required to exchange variation margin but the initial margin requirement is still being "phased in" on the basis of counterparties' "average daily aggregate notional amount" ("AANA"). The "Phase Four" compliance date—for counterparties having an AANA between $750 billion and $1.5 trillion—just occurred on September 1, 2019, and the compliance date for "Phase Five"—for counterparties with an AANA between $8 billion and $750 billion—is currently scheduled for September 1, 2020. Phase Five promises to be particularly challenging because, while only dozens of counterparties came into compliance through the first four phases, it has been estimated that more than a thousand counterparties would come into compliance in Phase Five. In accordance with the recent recommendations of the Basel Committee for Bank Settlements and the International Organization of Securities Commissions ("BCBS/IOSCO"), that created the original global framework for margining non-cleared derivatives in 2013, the Proposed Rules contain two forms of relief from the "Phase Five" implementation.
Delayed Compliance Date for Smaller Counterparties. Counterparties having an AANA of between $50 billion and $750 billion will remain subject to the September 1, 2020 "Phase Five" compliance date. However, the Proposed Rules would establish a new "Phase Six" compliance date of September 1, 2021, for counterparties having an AANA of between $8 billion and $50 billion. We would anticipate a similar move by the CFTC to be a matter of course. Somewhat awkwardly, the SEC refused to include "phased in" compliance dates for its margin rules because the SEC's anticipated compliance date at the time of adoption would have been later than the Phase Five compliance date of September 1, 2020. Now the SEC faces the potential for its margin rules to come into full force on a date that precedes the proposed "Phase Six" compliance date.
Documentation Requirements. Having another year to complete "Phase Six," however, does little other than offering a slight delay to decrease the ultimate documentation exercise for the thousand counterparties. However, the PR Margin Rules also permit a $50 million "threshold amount" before initial margin needs to be collected and received. Although many Phase Five/Six counterparties are not expected to reach this threshold, the PR Margin Rules would nevertheless arguably require the preparation of initial margin and triparty or third party custodial documentation prior to the applicable compliance date. The Prudential Regulators propose to clarify in the Proposed Rules that such documentation need not be in place until immediately before initial margin is required to be exchanged. This is in accordance with guidance from the ("BCBS/IOSCO") and with "no action" relief from the CFTC earlier this year (and with the SEC margin rules). It should be noted, however, that while this may lessen the documentation burden for many parties, swap entities will still be faced with the operational burden of tracking their counterparties' AANAs and initial margin requirements to ensure they do not exceed the various thresholds.
The most "controversial" of the Proposed Rules relates to the margin requirements for swaps between affiliates. The issue of whether and to what extent interaffiliate swap transactions should attract margin requirements has long been a topic of political debate, and even the regulators have taken differing positions. While the CFTC and the SEC have exempted interaffiliate transactions from initial (but not variation) margin, the PR Margin Rules currently require initial and variation margin to be exchanged between a swap entity and its affiliates.
In the Proposed Rules the Prudential Regulators propose simply to delete the initial margin requirement between affiliates (a concept that would be broadened to incorporate Bank Holding Company Act-like concepts of "control"). This would be in recognition of the fact that swap entity groups have accessed the public debt markets to the general detriment of their financial position in order to fund initial margin requirements in pursuit of debatable incremental risk management benefits. On the other hand, the Prudential Regulators were careful to observe that the Federal Reserve "continues to consider how interaffiliate non-cleared swaps can be addressed under [the Federal Reserve's] Regulation W."
Three Key Takeaways
- The Proposed Rules represent a more or less unqualified "win" for swap dealers and other swap entities who fall under the PR Margin Rules on an astonishingly broad range of issues.
- We would expect most of the Proposed Rules to be adopted more or less as proposed, and for the CFTC and SEC to follow suit eventually to the extent needed, but the interaffiliate initial margin exemption may face some political headwinds.
- One concern we have observed is that the relief for "replacement swaps" arising out of multilateral portfolio compression exercises seems definitionally ill-suited for "compensation swaps" that may be generated in the course of LIBOR transition. The Prudential Regulators should address this nuance when finalizing their amendments to the PR Margin Rules.
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