On December 16, 2015, the CFTC voted to adopt final rules that will establish minimum initial margin and variation margin requirements for uncleared swaps entered into by swap dealers and major swap participants that are not overseen by federal banking regulators (collectively, Swap Entities). The CFTC rules are substantially similar to the margin rules recently adopted by the federal banking regulators for entities subject to their regulatory oversight.
Rules Apply to Swap Entities and Financial End Users
The CFTC’s margin requirements vary depending on the nature of the counterparties to the uncleared swap. The CFTC’s rules establish three categories of counterparties: (1) Swap Entities, (2) financial end users, and (3) non-financial end users.
The CFTC defines the term “financial end user” to include the following types of entities:
Banks, savings and loan companies, credit unions, and their holding companies.
State-licensed finance companies, money lenders, mortgage brokers, and currency dealers.
Securities brokers and dealers, investment advisers, and investment companies.
Private investment funds, commodity pools, commodity pool operators, commodity trading advisors, floor brokers, floor traders, introducing brokers, and futures commission merchants.
Employee benefit plans.
Any person or entity that raises money from investors or uses its own money primarily for investing or trading in securities, swaps, or other assets.
A “non-financial end user” is defined as a counterparty that is neither a Swap Entity nor a financial end user.
Requirements for Initial Margin and Variation Margin
The CFTC’s margin rules will require daily posting and collecting of initial margin for all new swaps after the applicable compliance date between two Swap Entities or between a Swap Entity and a financial end user that has over $8 billion in gross notional exposure in uncleared swaps. The initial margin can be in the form of cash, sovereign debt, corporate bonds, equities, gold, and certain fund shares, with appropriate haircuts as specified in the rules.
With respect to variation margin, the rules will require daily payments in cash for all new swaps between two Swap Entities. For swaps between a Swap Entity and a financial end user (regardless of how much gross notional exposure in uncleared swaps it has), the rules require daily posting of variation margin in one of the forms approved for initial margin.
When margin is required to be posted, the CFTC rules will require the initial margin collateral to be held in segregated accounts at an independent custodian. Rehypothecation of the margin collateral is prohibited.
No Margin Required for Non-Financial End Users
Notably, the CFTC rules will not require non-financial end users to post initial margin or variation margin for uncleared swaps. Because such entities generally use swaps to hedge commercial risks, the CFTC believes that they pose less risk of default than financial entities. This treatment for non-financial end users was mandated by an amendment to the Dodd-Frank Act adopted by Congress in January 2015 to provide an exception for non-financial companies from the requirement to post margin on uncleared swaps.
Special Treatment for Inter-Affiliate Swap Transactions
The aspect of the CFTC’s margin rules that was most controversial was how those rules should apply to a swap between a Swap Entity and one of its affiliates. The margin rules adopted by the federal banking regulators require two-way initial margin and variation margin for swaps between a Swap Entity and an affiliate that is either a Swap Entity or a financial end user. However, commenters argued that inter-affiliate swap transactions are not outward-facing and thus do not increase the overall risk exposure of the consolidated enterprise to third parties. A majority of the CFTC (Chairman Massad and Commissioner Giancarlo) accepted that argument. Commissioner Bowen issued a dissenting statement in which she stated her view that the CFTC should have adopted the same approach as the banking regulators on this issue.