On November 7, 2019, five U.S. prudential regulators[1] published in the Federal Register significant amendments (including the accompanying release, the “PR Amendments”)[2] that they are proposing to modify the margin rules (the “PR Rules”)[3] for non-cleared swaps[4] applicable to swap dealers that are subject to prudential banking regulation.[5] The PR Amendments would end initial margin (“IM”) requirements in inter-affiliate swaps, facilitate the continuing phase-in of IM requirements and clarify that certain amendments of legacy swaps (including to accommodate the transition away from LIBOR) may be made without jeopardizing their grandfathered status. Comments on the PR Amendments are due by December 9, 2019.
IM for Inter-Affiliate Transactions
Under the current PR Rules, swap dealers must collect IM from their affiliates in connection with inter-affiliate swaps (but are not required to post IM to their affiliates).[6] The PR Rules’ imposition of IM on inter-affiliate swaps is unusual; the CFTC, in its margin rules, does not require IM in connection with inter-affiliate transactions, nor do the rules of most major non-U.S. jurisdictions.[7]
The PR Amendments would bring the PR Rules into closer conformity with the rules of other regulatory authorities by exempting inter-affiliate swaps from IM requirements (while retaining dealers’ obligation to exchange variation margin with affiliates). In addition to providing that the requirement for swap dealers to collect or post IM does not apply with respect to any swap with a counterparty that is an affiliate, the PR Amendments would make clear the broad scope of the “affiliates” for which no IM is necessary. They would expand the applicable definition of “affiliate” to include not only entities subject to consolidation under accounting rules but also entities falling within “the established ‘catch-all’ legal standard for affiliation in banking focusing on the direct or indirect exercise of controlling influence over the management or policies of the controlled company.”[8]
The release states several reasons for proposing to end IM requirements for inter-affiliate swaps. The Agencies’ experience has shown that inter-affiliate swaps are used by swap dealers “for internal risk management purposes whereby a banking organization transfers risk to a centralized risk management function, which is considered to be a prudent risk management practice.”[9] The Agencies express concern that as IM requirements have been phased in, banking organizations have borrowed increasing amounts of cash “to fund eligible collateral, placing additional demands on their asset-liability management structure and increasing their liability exposure to depositors and other creditors in the market.”[10] Moreover, the Agencies note, because other jurisdictions and regulatory bodies may not require IM for inter-affiliate swaps, the Agencies’ IM requirements may put entities subject to the PR Rules at a competitive disadvantage.[11]
The Agencies note that certain inter-affiliate transactions are subject to the requirements of sections 23A and 23B of the Federal Reserve Act, as implemented by the Board’s Regulation W, and that the “Board continues to consider how inter-affiliate non-cleared swaps can be addressed under Regulation W.”[12]
Facilitating IM Phase-In
The PR Amendments facilitate the continuing phase-in of IM requirements by (i) delaying 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 IM documentation in place with in-scope counterparties.
Delay of Required IM for Swaps with Smaller Financial End Users
The Proposed Rules would delay by one year the date by which swap dealers must comply with IM requirements in connection with non-cleared swaps with certain smaller financial end users.
Under the existing phase-in schedule for the margin rules for non-cleared swaps, September 1, 2020 is the compliance date for IM requirements for swaps between swap dealers and financial end users[13] 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 PR Amendments would 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 compliance date would remain September 1, 2020. However, for a second group, consisting of financial end users with $50 billion or less (but more than $8 billion)[14] in average daily aggregate notional amount of such transactions, the compliance date for IM requirements would be delayed by one year, until September 1, 2021.[15]
Explaining the reasoning for the proposed delay in the phase-in schedule, the PR Amendments note the operational complexity associated with IM and the difficulties associated with beginning to exchange IM with the large number of relatively small counterparties that, absent a rule change, would come into scope for IM in 2020. The Agencies further note that the extension by one year of IM requirements in connection with swaps with smaller counterparties is consistent with revisions in the international framework for margin adopted by the Basel Committee on Banking Supervision (“BCBS”) and the Board of the International Organization of Securities Commissions (“IOSCO”).[16]
Timing of Documentation Requirements
The PR Amendments would dispel 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.[17]
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.[18] 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 or post initial margin from or to a financial end user.[19] The PR Amendments would clarify 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) breaches the initial margin threshold amount.
The Agencies state their expectation that swap dealers will closely monitor their exposures and take appropriate steps to ensure that trading documentation is in place when IM is required to be exchanged. They also note the consistency of the PR Amendments with the approach of BCBS and IOSCO in their international framework for margin for non-centrally cleared derivatives regarding the timing of documentation.[20]
Amendments to 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.[21] 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 the PR Rules to apply to it and its entire netting portfolio.
The PR Amendments would address the concern that an amendment of a swap may cause the PR Rules 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 Amendments would provide 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[22] or (ii) another interest rate that a swap dealer “reasonably expects to be discontinued or reasonably determines has lost its relevance as a reliable benchmark due to a significant impairment.”[23] The safe harbor would also apply to a successor to an interest rate that might replace such a rate.
The PR Amendments would also permit adjustments or administrative or technical changes required to “operationalize the determination of payments” under the replacement rate, such as changes to determination dates, calculation agents, or payment dates, but they would not permit changes that would extend a swap’s maturity or increase its notional amount.[24]
Portfolio Compression Exercises
The PR Amendments would also permit the amendment of a swap by means of a portfolio compression exercise when the amendment occurs to reduce risk or stay risk-neutral. However, to fall within the safe harbor, the compression exercise must not result in the amended swap having a longer maturity or increased notional amount. Limitations on notional amount and maturity also apply to a swap entered into as a replacement reflecting the outcome of the compression exercise.[25]
Other Permitted Amendments
Other amendments for which the PR Amendments provide a safe harbor from the PR Rules 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.[26]
[1] The relevant regulators are the Board of Governors of the Federal Reserve System (the “Board”), 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, 84 Fed. Reg. 59970 (Nov. 7, 2019), available here.
[3] Margin and Capital Requirements for Covered Swap Entities, 80 Fed. Reg. 74840 (Nov. 30, 2015).
[4] The PR Rules and the PR Amendments 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 PR Amendments contain rules that 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] The rules governing the calculation of IM amounts for inter-affiliate transactions differ somewhat from rules for IM generally. See PR Rules at § _.11 (“Special rules for affiliates”), 80 Fed. Reg at 74909.
[7] See generally industry letter to the Agencies dated May 13, 2019, available here.
[8] PR Amendments, 84 Fed. Reg. at 59976. Specifically, the PR Amendments would add to the definition of “affiliate” for purposes of the IM exemption “[a]ny company that controls, is controlled by, or is under common control with the covered swap entity through the direct or indirect exercise of controlling influence over the management or policies of the controlled company.” 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.
[9] Id.
[10] Id.
[11] Id.
[12] 12 U.S.C. §§ _371c and 371c-1; 12 CFR part 223; PR Amendments at 59976.
[13] 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 certain financial end users. By reason of the rules’ phase-in schedule, which commenced on September 1, 2016, swap dealers are generally 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.
[14] 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.
[15] See PR Amendments at 59977, 59984.
[16] Id. at 59977.
[17] See id. at 59977, 59984.
[18] PR Rules at § _.10, 80 Fed. Reg. at 74908.
[19] See PR Rules at §§ _.2 (defining “initial margin threshold amount”) and .3 (“Initial margin”), 80 Fed. Reg. at 74901, 74902.
[20] PR Amendments at 59977.
[21] § _.5(a)(3) of the PR Rules, 80 Fed. Reg. at 74903.
[22] 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 Amendments at 59984.
[23] PR Amendments at 59984.
[24] Id.
[25] Id.
[26] Id.
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