On July 1, 2020, five U.S. prudential regulators[1] published in the Federal Register two separate rulemakings[2] containing significant amendments of the margin rules[3] for non-cleared swaps[4] applicable to swap dealers that are subject to prudential banking regulation.[5] Taken together, the New PR Rules substantially limit initial margin (“IM”) requirements arising from such swap dealers’ inter-affiliate swaps, facilitate the continuing phase-in of IM requirements, including by delaying remaining IM compliance dates, and clarify that certain amendments of legacy swaps, including to accommodate the transition away from LIBOR, may be made without jeopardizing their grandfathered status. The New PR Rules will take effect no later than September 1, 2020.[6]
IM for Inter-Affiliate Transactions
The PR Final Rule substantially limits the requirement that prudentially regulated swap dealers must collect IM from their affiliates in connection with inter-affiliate swaps (while not being required to post IM to their affiliates).[7] It accordingly brings the Agencies’ margin rules closer to the margin rules of the CFTC and of most major non-U.S. jurisdictions, which do not require IM in connection with inter-affiliate transactions.
The PR Final Rule requires swap dealers to calculate on each business day an IM collection amount for each relevant affiliate[8] and to collect IM from such affiliates in connection with inter-affiliate swaps only when the aggregate of all such calculated amounts exceeds 15 percent of the swap dealer’s tier 1 capital.[9] Because the rule limits the IM collection requirement to such circumstances, its real-world impact may be limited; the Agencies “have observed” that swap dealers “have collected inter-affiliate initial margin under the current rule at levels that do not exceed this limit.”[10] In addition, the IM collection requirement generally does not apply to non-U.S. swap dealers.[11]
When the revised rule does require the collection of IM, it will do so only on an incremental basis, that is, only in connection with “additional” swaps that put the IM collection amount over the 15 percent threshold, and only for so long as the aggregate IM collection amount remains above that threshold.[12] Further, the PR Final Rule incorporates a broad definition of the “affiliates” for which IM requirements are limited, expanding the applicable definition of “affiliate” to include not only entities subject to consolidation under accounting rules but also “[a]ny company that controls, is controlled by, or is under common control with the [swap dealer] through the direct or indirect exercise of controlling influence over the management or policies of the controlled company.” [13]
The PR Final Rule leaves in place the requirement that swap dealers exchange variation margin with their affiliates.
Facilitating IM Phase-In
The New PR Rules facilitate the continuing phase-in of IM requirements by (i) cumulatively delaying by as long as two years the date by which swap dealers must comply with IM requirements in connection with swaps with certain smaller financial end users and (ii) clarifying the date by which swap dealers must put in place IM documentation with in-scope counterparties.
Delay of Required IM for Swaps with Smaller Financial End Users
The New PR Rules, taken together,[14] will delay by as much as two years the date by which swap dealers must comply with IM requirements in connection with non-cleared swaps with certain smaller financial end users.
Under PR Rules’ original phase-in schedule, September 1, 2020 was the compliance date for IM requirements for swaps between swap dealers and financial end users[15] that, combined with their affiliates, have $0.75 trillion or less in average daily aggregate notional amount of non-cleared swaps, non-cleared security-based swaps, foreign exchange forwards and foreign exchange swaps.
The New PR Rules divide such financial end users into two groups. For one group, consisting of financial end users with more than $50 billion (but $0.75 trillion or less) in average daily aggregate notional amount of such transactions, the IM compliance date will be September 1, 2021. For a second group, consisting of financial end users with $50 billion or less (but more than $8 billion)[16] in average daily aggregate notional amount of such transactions, the IM compliance date will be September 1, 2022.[17]
The Agencies base their postponement of the IM compliance dates on concerns about the difficulties associated with beginning to exchange IM with the large number of relatively small counterparties, in the case of the PR Final Rule,[18] and on concerns regarding the impact of the global COVID-19 pandemic, in the case of the PR Interim Final Rule.[19] The Agencies note that the postponed compliance dates are generally in accordance with the revisions in the international framework for margin adopted by the Basel Committee on Banking Supervision and the Board of the International Organization of Securities Commissions.[20]
Timing of IM Documentation Requirements
The PR Final Rule dispels confusion over when IM documentation is required to be executed in any given trading relationship, clarifying that a swap dealer need not execute IM trading documentation with a counterparty prior to the time when it is required to collect or post IM with that counterparty.
The PR Rules provide that a swap dealer “shall execute” trading documentation with “each” financial end user that provides the swap dealer and its counterparty with the contractual right to collect and post IM (and variation margin) in such amounts, in such form, and under such circumstances as are required by the PR Rules.[21] However, the PR Rules also provide for a $50 million initial margin threshold amount, representing an aggregate credit exposure resulting from all non-cleared swaps and non-cleared security-based swaps between a swap dealer and its affiliates, and a counterparty and its affiliates, below which a swap dealer need not collect IM from, or post IM to, a financial end user.[22]
The PR Final Rule clarifies that, even if a counterparty is in scope for IM by reason of having both material swaps exposure and the required average daily aggregate notional amount of relevant transactions, no IM documentation must be in place until the exposure resulting from transactions between the counterparty (and its affiliates) and the swap dealer (and its affiliates) exceeds the initial margin threshold amount and initial margin is required to be collected or posted. [23]
Amendments of Legacy Transactions
The PR Rules provide that they will not apply to legacy transactions entered into before the applicable compliance date of the PR Rules, but only if such legacy transactions are within a netting portfolio that contains only swaps entered into before that compliance date.[24] However, the PR Rules do not generally address the circumstances in which an amendment of an uncleared swap may be deemed to constitute a new transaction, thus potentially causing margin requirements to apply to such swap and its entire netting portfolio.
The PR Final Rule addresses the concern that an amendment of a swap may cause margin requirements to apply to it and its netting portfolio by providing safe harbors for certain types of amendments.
LIBOR Replacement
In view of the looming phase-outs of LIBOR and other interbank offered rates (each, an “IBOR”), the PR Final Rule provides a safe harbor for amendments to swaps made solely to accommodate the replacement of (i) an IBOR, including, but not limited to, one of seven enumerated IBORs[25] or (ii) another interest rate that a swap dealer “reasonably expects to be replaced or discontinued or reasonably determines has lost its relevance as a reliable benchmark due to a significant impairment.”[26] The safe harbor also applies to a successor to an interest rate that might replace such a rate.
The PR Final Rule also permits portfolio compression exercises between swap dealers and their counterparties as means of amending swaps to replace IBORs. Any non-cleared swaps resulting from such a portfolio compression exercise may not have a longer maturity or increased notional amount to a greater extent than is necessary to accommodate the differences between market conventions for an outgoing interest rate and its replacement.[27]
In addition, the PR Final Rule permits adjustments or technical changes required to “operationalize the determination of payments” under a replacement rate, including changes to determination dates, calculation agents, or payment dates, but such changes may not extend maturity or increase a notional amount to a greater extent than is necessary to accommodate the differences between market conventions for an outgoing interest rate and its replacement.[28]
Portfolio Compression Exercises
The PR Final Rule also permits the amendment of a swap by means of a portfolio compression exercise when the amendment occurs to reduce risk or stay risk-neutral. Limitations on notional amounts and maturity apply to the swaps resulting from the compression exercise.[29]
Other Permitted Amendments
Other amendments for which the PR Final Rule provides a safe harbor from the application of margin requirements include amendments to reflect (i) administrative or operational changes, provided that they do not alter the swap’s underlier, remaining maturity or notional amount and (ii) reductions in notional amount, provided that all payment obligations related to the eliminated portion of the notional amount are fully terminated or novated to a third party that complies with applicable margin rules as transferee.[30]
[1] The relevant regulators are the Board of Governors of the Federal Reserve System, the Farm Credit Administration, the Federal Deposit Insurance Corporation, the Federal Housing Finance Agency and the Office of the Comptroller of the Currency (collectively, the “Agencies”).
[2] Margin and Capital Requirements for Covered Swap Entities, 85 Fed. Reg. 39754 (July 1, 2020) (the “PR Final Rule”); Margin and Capital Requirements for Covered Swap Entities 85 Fed. Reg. 39464 (July 1, 2020) (the “PR Interim Final Rule” and, together with the PR Final Rule, the “New PR Rules”).
[3] Margin and Capital Requirements for Covered Swap Entities, 80 Fed. Reg. 74840 (Nov. 30, 2015) (such rules, prior to their amendment by the New PR Rules, the “PR Rules”).
[4] The PR Rules and the New PR Rules relate to both the “swaps” that are primarily regulated by the Commodity Futures Trading Commission (“CFTC”) and the “security-based swaps” that are primarily regulated by the Securities and Exchange Commission (“SEC”). For simplicity and readability, in this client alert we generally refer to all such transactions as “swaps.”
[5] The PR Rules and the New PR Rules apply to the registered swap dealers and major swap participants that are subject to regulation by the CFTC and to the registered security-based swap dealers and major security-based swap participants that are subject to regulation by the SEC if, in each case, such entity is also subject to prudential banking regulation. Given the rarity of major swap participants, and given that there are not yet any registered security-based swap dealers or major security-based swap participants, in this client alert we refer to all such prudentially regulated parties as “swap dealers.” The margin rules of the CFTC apply to swap dealers and major swap participants that are not prudentially regulated (see Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 81 Fed. Reg. 636 (Jan. 6, 2016)), and the margin rules of the SEC apply to security-based swap dealers and major security-based swap participants that are not prudentially regulated (see Capital, Margin, and Segregation Requirements for Security-Based Swap Dealers and Major Security-Based Swap Participants, 84 Fed. Reg. 43872 (Aug. 22, 2019)).
[6] See PR Interim Final Rule, 85 Fed. Reg. at 39467; footnote 14 below.
[7] The Agencies had proposed to exempt swap dealers entirely from IM collection requirements with affiliates. See Margin and Capital Requirements for Covered Swap Entities, 84 Fed. Reg. 59970 (Nov. 7, 2019). Their determination to require IM collection in limited circumstances reflects the Agencies’ safety and soundness concerns, particularly concerns that may arise at a swap dealer "whose tier 1 capital base is contracting in an unusually rapid pattern, a situation that evidences the institution is experiencing heightened levels of stress, or whose inter-affiliate derivative exposures increase in an unusually rapid pattern.” PR Final Rule at 39762-63.
[8] IM requirements apply in relation to a swap between a swap dealer and either another swap dealer or a financial end user with material swaps exposure. See footnotes 15 and 16 below.
[9] PR Final Rule, 85 Fed. Reg. at 39772. For these purposes, “tier 1 capital” is defined to mean the sum of common equity tier 1 capital as defined in 12 CFR 3.20(b) and additional tier 1 capital as defined in 12 CFR 3.20(c), as reported in the institution’s most recent Consolidated Reports of Income and Condition (Call Report). Id.
[10] PR Final Rule, 85 Fed. Reg. at 39762
[11] See id. at 39763, 39772.
[12] Id. at 39772.
[13] Id. at 39773. We would expect that the “controlling influence” analysis would track the analysis required under the particular Agency’s definition of “control” used for other purposes. In general, the analysis of whether one company exercises a controlling influence over another company is complex and involves an assessment of the totality of the relationship between the two companies, including consideration of total equity (including non-voting), business relationships, board representation and restrictive covenants, among other things.
[14] Each of the PR Final Rule and PR Interim Final Rule incrementally amends the phase-in schedule for IM requirements for swaps with smaller financial end users, with the PR Interim Final Rule setting out the second set of incremental changes. The Agencies split the amendment of the phase-in schedule into two separate rulemakings because, while market participants had an opportunity to comment on the PR Final Rule, they did not have an opportunity to comment on the PR Interim Final Rule. See PR Interim Final Rule, 85 Fed. Reg. at 39467. To ensure proper sequencing, the PR Final Rule will become effective on August 31, 2020 and the PR Interim Final Rule will become effective on September 1, 2020. Id. The Agencies have invited public comment on the PR Interim Final Rule.
[15] The term “financial end user” is defined at length in §__.2 of the PR Rules. See 80 Fed. Reg. at 74900-01. Generally the PR Rules apply to transactions either between two different swap dealers or between swap dealers and financial end users. By reason of the rules’ phase-in schedule, which commenced on September 1, 2016, swap dealers are already subject to IM requirements in connection with transactions with other swap dealers. The phase-in period for variation margin requirements under the PR Rules ended in 2017.
[16] The Agencies’ IM requirements apply to swaps between swap dealers and only those financial end users with “material swaps exposure,” generally defined to mean an average daily aggregate notional amount of non-cleared swaps, non-cleared security-based swaps, foreign exchange forwards and foreign exchange swaps that exceeds $8 billion. Swap dealers are required to both collect IM from, and post IM with, such financial end users.
[17] PR Interim Final Rule, 85 Fed. Reg. at 39468-69.
[18] See PR Final Rule, 85 Fed. Reg. at 39765.
[19] See PR Interim Final Rule, 85 Fed. Reg. at 39464.
[20] PR Final Rule, 85 Fed. Reg. at 39765; PR Interim Final Rule, 85 Fed. Reg. at 39466.
[21] PR Rules at §__.10, 80 Fed. Reg. at 74908.
[22] See PR Rules at §§__.2 (defining “initial margin threshold amount”) and __.3 (“Initial margin”), 80 Fed. Reg. at 74901, 74902.
[23] PR Final Rule, 85 Fed. Reg. at 39772.
[24] PR Rules at §__.5(a)(3), 80 Fed. Reg. at 74903.
[25] The seven enumerated interbank offered rates are the London Interbank Offered Rate (LIBOR), the Tokyo Interbank Offered Rate (TIBOR), the Bank Bill Swap Rate (BBSW), the Singapore Interbank Offered Rate (SIBOR), the Canadian Dollar Offered Rate (CDOR), Euro Interbank Offered Rate (EURIBOR) and the Hong Kong Interbank Offered Rate (HIBOR). PR Final Rule, 85 Fed. Reg. at 39771.
[26] PR Final Rule, 85 Fed. Reg. at 39771.
[27] Id. at 39772.
[28] Id.
[29] Id.
[30] Id.
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