On October 31, the Division of Swap Dealer and Intermediary Oversight (Division) of the Commodity Futures Trading Commission (CFTC) issued a staff interpretation regarding the notification of the right to segregation of initial margin in uncleared swap transactions.1 The interpretation also addressed quarterly reporting requirements applicable to swap dealers (SDs) and major swap participants (MSPs) under CFTC Regulations 23.7012 and 23.704.3
Notification Requirement. CFTC Regulation 23.701 requires that an SD or MSP notify its counterparty that it has the right to require segregation of any initial margin posted to the SD or MSP in connection with a transaction, prior to entering into that transaction. As part of this notification, the SD or MSP must identify one or more acceptable independent custodians (at least one of which must be a creditworthy and unaffiliated financial institution) with whom the initial margin will be held, and provide certain pricing information regarding the costs of segregation, to the extent the SD or MSP has such information.4 SDs and MSPs are required to provide this notice on an annual basis to an officer of the counterparty responsible for collateral management (or to another officer specified by the counterparty)5 and must obtain both confirmation of receipt of the notice and an election of whether or not to segregate the initial margin.6
Although the policy behind this requirement is beneficial to end-user counterparties because it requires SDs and MSPs to annually inform them of their statutory right7 to segregation with respect to any initial margin required to be posted, both SDs/MSPs and end-users have expressed confusion concerning the application of the rule in certain circumstances. For example, does the SD or MSP have to continue to provide notice to a counterparty if that counterparty has selected segregation of initial margin, and such election has not been revoked? Must the SD or MSP provide the notice if the parties have no agreement between them relating to the posting of initial margin? What happens if an SD or MSP sends out a notice to a counterparty in compliance with the relevant rules, but the counterparty does not respond with its election?
Reporting Requirement. CFTC Regulation 23.704 requires than an SD or MSP provide quarterly reports to each counterparty not choosing to require segregation of the SD’s or MSP’s back office procedures relating to margin and collateral, and if such procedures were out of compliance with the swap agreement of the counterparties within the past quarter.8 This reporting requirement is intended to allow counterparties to regularly monitor how an SD or MSP is handling initial margin that has been posted but is not required to be segregated. Dealers have expressed concern, however, that this reporting requirement is overly burdensome and has no practical effect in circumstances where a counterparty is not required to post any initial margin.
To address these concerns, the Division’s interpretation clarified the notice and reporting requirements as follows:
(1) The SD or MSP must continue to provide annual notice of the right to require segregation of initial margin to the counterparty even if there has been no revocation of a prior election, unless the parties have not entered into an uncleared swap transaction since the initial election was made;
(2) In the absence of a contractual or regulatory requirement for a counterparty to post initial margin to the SD or MSP (e.g., if no initial margin is specified in an ISDA Credit Support Annex9 or confirmation to an uncleared swap transaction), the SD or MSP is not required to provide the annual notice under Regulation 23.701 or provide the quarterly reports under Regulation 23.704; and
(3) In the event an SD or MSP does not receive a response from a counterparty after providing notice to an appropriate representative of the counterparty, the SD or MSP may assume that the counterparty has not elected segregation of initial margin; provided, however, that the notice must have included a provision relating to negative consent (i.e., that a lack of response can be interpreted as an election not to require segregation of initial margin).
1 CFTC Interpretation 14-132 can be found at http://www.cftc.gov/PressRoom/PressReleases/pr7049-14.
2 17 C.F.R. §.23.701 can be found at http://www.gpo.gov/fdsys/pkg/CFR-2014-title17-vol1/pdf/CFR-2014-title17-vol1-sec23-701.pdf.
3 17 C.F.R. §.23.704 can be found at http://www.gpo.gov/fdsys/pkg/CFR-2014-title17-vol1/pdf/CFR-2014-title17-vol1-sec23-704.pdf.
4 The International Swaps and Derivatives Association, Inc. (ISDA) has published a Form of CFTC IM Segregation Right Notice, which can be found here: http://www2.isda.org/functional-areas/infrastructure-management/collateral/.
5 If the counterparty does not provide any contacts, the SD or MSP must notify the Chief Executive Officer, or otherwise the highest ranking decision-maker of the counterparty.
6 Market participants have the ability to designate an appropriate contact person for purposes of this notice, as well as elect whether or not initial margin must be segregated, through ISDA Amend, which can be accessed here: http://www.markit.com/product/isda-amend. This service is free to end-user market participants.
7 Section 4s(l) of the Commodity Exchange Act.
8 ISDA has published a form of CFTC 23.704 Quarterly Notice for this purpose, which can be found here: http://www2.isda.org/functional-areas/infrastructure-management/collateral/.
9 Initial margin is referred to as an “Independent Amount” in the ISDA Credit Support Annex.
