New regulations issued last week on margin and capital requirements for uncleared swaps significantly reduced the amount of initial margin required to support uncleared swap transactions between banks and their affiliates.
The joint final rule published Oct. 22 by the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corp. does not require U.S.-regulated banks to post initial margin in transactions with their affiliates; only the affiliates must do so. Regulators had initially proposed requiring two-way initial margining. The relief granted in the final rule is meaningful to the largest U.S. banks, which generally use interaffiliate transactions under their global booking models to manage risk efficiently by consolidating it or transferring exposures to the entities best able to manage them. However, the final rule is likely to apply to more transactions than initially proposed, as it lowered the threshold for interaffiliate initial margin to $20 million from $65 million.
Covered swap entities under the OCC and FDIC rule include registered swap dealers, major swap participants, security-based swap dealers, and major security-based swap participants. The Board of Governors of the Federal Reserve System, the Securities and Exchange Commission, and the Commodity Futures Trading Commission have not yet adopted final rules, but they are expected to be substantially similar to the OCC and FDIC final rule. The joint final rule implements sections 731 and 764 of the Dodd-Frank Act and does not apply to financial institutions with $10 billion or less in total assets that enter into swaps for hedging purposes; commercial end users who enter into swaps to hedge commercial risk are also exempt.
The rule includes new requirements for covered swap entities in:
- Initial margin, including posting, collection, and calculation
- Variation margin, including posting and collection
- Netting arrangements, minimum transfer amount, and satisfaction of posting and collection requirements
- Eligible collateral for uncleared swaps with a swap entity or financial end user
- Segregation of collateral
- Initial-margin models and standardized amounts
- Cross-border application
- Special rules for affiliates
Several of the rules relating to interaffiliate transactions are substantially different from those initially proposed:
- One-way initial margin: Covered entities are not required to post initial margin to any affiliate that is not a covered swap entity (i.e., a financial end user with material swap exposure). The proposal would have required the posting of two-way initial margin for swaps between covered swap entities and affiliates that are financial end users. Although the posting and collecting of initial margin are not required for these transactions, covered swap entities must calculate the amount of initial margin that would be required if margin were posted and provide documentation of the calculation to the affiliate daily.
- Initial-margin threshold: The final rule clarified that the initial-margin threshold for interaffiliate transactions is an aggregate credit exposure of $20 million, resulting from all uncleared swaps and uncleared security-based swaps between the covered swap entity and each affiliate. This is a substantially lower amount than the $65 million threshold in the proposal and the $50 million initial-margin threshold for nonaffiliate covered transactions. The $50 million initial-margin threshold applies on a consolidated-entity level.
- Variation margin: Covered swap entities are required to collect and post variation margin on uncleared swaps and uncleared security-based swaps with affiliate counterparties daily.
- Custodian for noncash collateral: If the covered swap entity collects noncash collateral from an affiliate, the covered swap entity may serve as the custodian for the collateral or have an affiliate serve as the custodian.
- Model holding period: For swaps with an affiliate that are exempt from mandatory clearing, covered swap entities may use a holding period in their margin-calculation model equal to the shorter of five business days or the maturity of the uncleared swap or uncleared security-based swap, so long as the initial-margin amount is calculated separately from other swaps.
The final rule’s capital requirements for uncleared swaps are unchanged from the FDIC’s and OCC’s proposed rule; a covered swap entity must comply with risk-based and leverage capital requirements already applicable to the covered swap entity.
The joint final rule is effective April 1, 2016. Compliance with initial-margin requirements is phased in, and ranges from Sept. 1, 2016, to Sept. 1, 2020, depending on the average daily aggregate notional amount of uncleared swaps, uncleared security-based swaps, foreign-exchange forwards, and foreign-exchange swaps of the covered swap entity and its counterparty (and their respective affiliates) for each business day in March, April, and May of the corresponding year. Covered swap entities are expected to comply with the joint final rule’s variation-margin requirements by Sept. 1, 2016, if the covered swap entity combined with all affiliates, and its counterparty combined with all its affiliates, has an average daily aggregate notional amount of covered swaps for March, April, and May 2016 that exceeds $3 trillion. All other covered swap entities are expected to comply with the final rule’s variation-margin requirements no later than March 1, 2017.
Though the joint final rule does provide relief on initial margin, it imposes additional financial requirements on uncleared interaffiliate swap transactions. In response, large banks may:
- Continue engaging in interaffiliate transactions as they have
- Move the booking of certain client-facing transactions to the regional or regulated entity that is best able to manage the transaction’s risk
- Hedge certain transactions using less efficient methods than interaffiliate transactions
- Allow exposure arising from certain client-facing transactions to go unhedged
Regardless of the choice the bank makes, any higher costs (either financial or operational) associated with supporting the original client-facing transaction could be passed on to the bank’s client.
Please contact us to discuss how Promontory can help your company develop a compliance program to meet the new margin requirements, or to ask any questions you have about our swap-related advisory services.
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1. Currently, there are only provisionally registered swap dealers and major swap participants; there are no registered security-based swap dealers or major security-based swap participants.
2. The Federal Reserve Board will consider its final rule on Oct. 30.
3. Sections 731 and 764 of the Dodd-Frank Act impose capital and margin requirements on swap entities that: 1) help ensure the safety and soundness of the swap entity; and 2) are appropriate for the greater risk associated with uncleared swaps.
4. The comment to the final rules provides that a covered swap entity “may” establish a threshold of $20 million for interaffiliate transactions, whereas the text of the final rules reads: “For purposes of calculating the amount of initial margin to be collected from an affiliate counterparty … the initial margin threshold is [emphasis added] an aggregate credit exposure of $20 million resulting from all non-cleared swaps and non-cleared security-based swaps between the covered swap entity and that affiliate.”