The swaps market is in for another upheaval — effective March 1, 2017, financial entity swap participants will need to comply with new variation margin regulations, most likely by agreeing to a new International Swaps and Derivatives Association (ISDA) protocol available on ISDA Amend 2.0. The new protocol provides for mandatory bilateral initial and variation margin on many swaps that are not centrally cleared. If you do not have the 2016 ISDA Variation Margin Protocol in place by March 1, 2017, or agree to another solution with your swap counterparties, your swap counterparties will likely stop doing business with you until you do and you will not be able to enter into new swap trades.

Prior to the Dodd-Frank Act of 2010 (Dodd-Frank), most swaps and other derivatives were largely unregulated in the United States. As a result of Dodd-Frank, virtually all swaps and derivatives are now regulated, primarily by the Commodity Futures Trading Commission (CFTC) and, to a lesser extent, the Securities and Exchange Commission (SEC) and various federal banking regulators. In addition, under Dodd-Frank, the vast majority of derivatives are considered “swaps,” including many that were not previously considered swaps, such as caps, collars, floors and similar financial derivatives. Dodd-Frank has also forced a portion of what has historically been called “over-the-counter swaps,” or “OTC swaps,” into centralized execution and clearing. Despite this, these swaps are still commonly referred to as “OTC swaps.”

As swap market participants are all too aware, documentation for swaps is complex and can be difficult to understand, even when the actual economics of a swap trade are simple. Because of the implementation of new regulatory requirements relating to both variation and initial margin for swaps (New Swap Margin Regulations), swap documentation for many market participants is about to become much more complicated.

Where did the New Swap Margin Regulations come from?

These new regulatory requirements are driven by the international framework for margin requirements for swaps that was finalized in September 2013 (the International Framework) by the Basel Committee on Banking Supervision and the Board of the International Organization of Securities Commissions. Since the driving force behind the New Swap Margin Regulations is an international multilateral agreement, the basic regulatory requirements are or will be similar across major international financial markets. This international standardization is intended to limit the ability of market participants to engage in regulatory arbitrage. In addition, regardless of the regulatory stay imposed by the Trump administration in the United States, these regulatory requirements seem likely to remain.

While this client alert focuses on the swap regulatory regime in the United States, it is important to note that the European Union, Japan, Switzerland and Canada all have either finalized regulations similar to the New Swap Margin Regulations, or are about to. There are technical, and not so technical, differences between the swap regulatory regimes in the various jurisdictions. The jurisdiction of your swap counterparties may also subject you to the regulatory regime of the counterparties’ domiciles. We urge you to contact appropriate counsel if you believe that you are subject to a non-U.S. swap regulatory regime, and, if you do not have such counsel, please contact us for suggestions.

What is the policy thinking behind the New Swap Margin Regulations?

There is a broadly held view that swaps are risky and perhaps, in some circumstances, riskier than swap users may expect or understand. Swaps can, for example, concentrate risk in the hands of a small number of users or counterparties, which may give rise to concerns of systemic importance. According to that view, it is possible for a large swap user to unwittingly mismanage its swap risk and become insolvent, defaulting on its obligations to other swap users and eventually resulting in general market contagion and widespread financial failures of swap users.

This view is not just theoretical. American International Group (AIG) suffered very large swap related losses in 2007-2008, and there were widespread fears of resulting market contagion. AIG was a very large swap market participant, and a great deal of the total market risk of certain types of swaps was concentrated at AIG. Ultimately, the U.S. government had to bail out AIG. The swaps that caused so much trouble for AIG were OTC swaps that were not centrally cleared and did not reflect standardized terms for a fungible market. It is important to note that the regulatory rules at the time did not require AIG to post variation margin; that was up to its swap counterparties to require. In fact, AIG generally was not required by its counterparties to post variation margin on these swaps so long as AIG maintained a certain credit rating. AIG apparently ran its OTC swaps business based on the assumption that it would maintain its credit rating and would never have to post variation margin. When AIG’s credit rating was downgraded at the same time that its OTC swap positions suffered large mark-to-market losses, AIG was unable to post sufficient variation margin based on its own resources. If AIG had been allowed to default on its obligations to its counterparties, the absence of, or insufficient, posted variation margin would have meant that its counterparties were likely to suffer immediate and very large losses. The endgame for AIG was essentially a large federal government bailout.

As a result of AIG and similar episodes that played out in the market turmoil of 2007-2008, Dodd-Frank was enacted with a goal of, among other things, reducing the systemic market risk created by swaps. Dodd-Frank did not intend to make swap transactions riskless for the participants in any given swap, but rather to contain the risk of that transaction to those participants. Dodd-Frank uses several tools to reduce market risk created by swaps. First, Dodd-Frank requires certain swaps to be cleared at a central clearing house that will impose margin requirements on its members. Second, the New Swap Margin Regulations impose mandatory initial and variation margin requirements on many swaps that are not centrally cleared. Together, the margin requirements imposed by clearing houses and the New Swap Margin Regulations impose margin requirements on most types of swaps. Where certain swaps are still exempt from margin requirements, it is because they are thought to either be lower risk or not numerous or concentrated enough to cause market contagion.

Which regulator created the New Swap Margin Regulations?

In the United States, most swaps are regulated by the CFTC while certain securities-based swaps are regulated by the SEC. In addition, the federal banking regulators have a more limited regulatory role. Certain physically settled foreign exchange forwards and foreign exchange swaps are generally exempt from swap regulation in the United States as a result of a determination made by the Secretary of the U.S. Department of the Treasury (such foreign exchange transactions are referred to as “Excluded FX Transactions”).

On December 16, 2015, the CFTC adopted final rules (the CFTC Final Rules) to establish initial margin and variation margin requirements for uncleared swaps, i.e., swaps that are not cleared by a derivatives clearing organization or exchange. The CFTC Final Rules apply to market participants that are subject to the CFTC’s jurisdiction and are generally consistent with the final rules promulgated on October 22, 2015 by the Board of Governors of the Federal Reserve System, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the Farm Credit Administration and the Federal Housing Finance Agency (collectively, the Prudential Regulators). These final rules set initial margin and variation margin requirements for uncleared swaps that are (1) not cleared by a clearing house and (2) entered into by swap dealers, major swap participants, security-based swap dealers and major security-based swap participants subject to the jurisdiction of one of the Prudential Regulators (the Prudential Regulators’ Final Rules and, together with the CFTC Final Rules, the Final Rules).

The SEC generally has jurisdiction over security-based swaps, which are primarily swaps for which the reference obligation is a single security or a narrow-based index of securities (Security-Based Swaps). The SEC has not yet finalized its version of the New Swap Margin Regulations, so, at first glance, it would appear that there are no new initial or variation margin rules applicable to Security-Based Swaps and no new documentation requirements. However, the dealer party to a Security-Based Swap is likely to be subject to regulation by the Prudential Regulators, including the New Swap Margin Regulations. Therefore, as a practical matter, Security-Based Swaps are subject to the New Swap Margin Regulations by way of the limitations imposed by the Prudential Regulators.

ISDA is a private organization, and not a regulator. However, ISDA publishes many widely used standard agreements and templates for derivatives transactions, and thus it indirectly has influence on both the regulatory scheme and how market participants respond.

What is the scope of the New Swap Margin Regulations?

The New Swap Margin Regulations are not retroactive with respect to existing transactions, and, therefore, there is no requirement to enter into new documentation for existing transactions. That is, the New Swap Margin Regulations apply only to transactions entered into on or after March 1, 2017. In addition, new confirmations under existing or new ISDA Master Agreements are considered new transactions and therefore are subject to the New Swap Margin Regulations. New transactions, unless exempt, will have to comply with the New Swap Margin Regulations, including applicable new documentation. The New Swap Margin Regulations generally apply to financial end users, such as hedge funds, private equity funds, registered investment companies (including mutual funds), employee benefit plans, insurance companies and many organizations engaged in a banking or lending business. This definition of “financial end user” was created by the New Swap Margin Regulations and is not the same as the “end user” definition used in other swap regulations.

Pepper Points

• If your business is financial in nature, the New Swap Margin Regulations probably apply to you.

• Swaps eligible for the commercial end-user exception to mandatory clearing, based on Section 2(h)(7)(A) of the Commodity Exchange Act, and Excluded FX Transactions are generally exempt from the New Swap Margin Regulations.

• Cleared swaps are subject to a different variation margin regime and, in addition, generally are not documented using ISDA forms.

ISDA has published the Regulatory Margin Self-Disclosure Letter (the Self-Disclosure Letter), which is a questionnaire that dealers may send to buy-side participants in order to determine if the New Swap Margin Regulations are applicable and, if so, when and how. The Self-Disclosure Letter is merely an information-gathering tool; it is not an operative document and therefore not a document that needs to be adjusted or executed.

When are the New Swap Margin Regulations effective?

Time is short: If a buy-side swap user engages in a new swap transaction on or after March 1, 2017, the New Swap Margin Regulations with respect to variation margin will be applicable to that transaction unless the transaction is exempt.

If a buy-side swap user engages in a new swap transaction on or after September 1, 2020, the New Swap Margin Regulations with respect to initial margin will be applicable to that transaction unless the transaction is exempt. Initial margin requirements were introduced on September 1, 2016 for the largest swap participants and will continue to be phased in until September 1, 2020. If the buy-side user has very large swap positions, their compliance date with respect to initial margin will be earlier and, in fact, may already have occurred.

What is the difference between variation and initial margin?

Initial margin is a fixed amount set at the time the transaction is entered into based on the notional amount of the trade. This amount is intended to protect a non-defaulting party when a counterparty cannot meet its obligations under the swap.

Variation margin is the mark-to-market amount posted by one party to the other party reflecting change in value of the swap and is intended to bring the total margin up to a suitable level when the trade has moved against a party. For example, if Party A and Party B enter into an interes- rate swap, and the swap has a value today of $10 to Party B, then Party A would have to post $10 of variation margin to Party B. Variation margin is usually calculated and posted daily.

Pepper Point

• Registered investment companies, such as mutual funds, are under stringent custody rules imposed by the Investment Company Act of 1940, as amended. All assets — including initial and variation margin for swaps — must be held by the custodian appointed by the board of the registered investment company and may not be deposited with the counterparty. Accordingly, registered funds must use tri-party “account control agreements” with the custodian bank, the swap counterparty and the fund as parties to segregate the initial and variation amounts on the books of the custodian for the benefit of both the counterparty and the fund and to control properly the disbursement of funds under the swap documentation.

Why should I be concerned about the New Swap Margin Regulations? I already post initial and variation margin with my counterparties and have an ISDA Credit Support Annex (CSA) with each of my counterparties.

The New Swap Margin Regulations require, among other things, (1) that the margin be calculated by reference to either a standard table published by the applicable regulator or an approved model, (2) aggregating initial and variation margin differently than a standard CSA does, (3) different timing for the posting of collateral than is likely to be included in your CSA, (4) new dispute resolutions procedures and (5) that only certain types of collateral are eligible for posting. In short, your existing CSA is not compliant for new transactions that are subject to the New Swap Margin Regulations. If your swap documentation with your dealers is not compliant with the New Swap Margin Regulations on March 1, 2017, you probably will not be able to enter into new swap trades.

I need to be able to enter into new swaps after March 1, 2017. What should I do now?

We suggest that you contact your swap dealers as soon as possible. They may send you the Self-Disclosure Letter so that they can determine what situation is applicable to you. Remember that rules similar to the New Swap Margin Regulations already exist or will exist shortly in a number of important jurisdictions. It is important to consider the domiciles of your swap dealers and the domiciles of your swap activities. Swap dealers have a great deal to do between now and March 1, 2017, and, while we believe they will make every effort to have their customers compliant on March 1, 2017, we believe it is prudent to contact them now to ensure that the correct actions are being taken.

I just spoke to my swap dealer, and he says that I need to enter into the ISDA Variation Margin Protocol (I am not yet subject to the mandatory initial margin rules). What do I need to do? Do I have any choices?

The ISDA Variation Margin Protocol is complicated and requires paying a fee to ISDA and using an online system. It is not the only way to comply with the New Swap Margin Regulations. We believe that dealers are likely to determine the applicable manner of documenting compliance with the New Swap Margin Regulations. Some dealers may choose to send you a new CSA or an amendment to your existing CSA to execute; they may feel this is easier and cheaper than using ISDA’s online ISDA Amend 2.0 system. If the dealer follows this route, you need to carefully consider whether you will lose the benefit of any provisions in your existing CSA that are compliant with the New Swap Margin Regulations but that are not included in the new or amended CSA sent by the dealer. If you have complicated swap documentation — for example a highly negotiated CSA bridged to your prime brokerage and futures accounts — you need to proceed carefully to ensure that everything still works after the substitution of the new CSA.

Our dealer wants us to go ahead and use ISDA Amend 2.0 and the Variation Margin Protocol. How does this work?

You will use ISDA Amend 2.0 to complete the ISDA 2016 Variation Margin Protocol Questionnaire (the Questionnaire). The Questionnaire you complete will be automatically compared to the Questionnaire completed by the dealer. The matched Questionnaires will be used to generate a new Credit Support Annex (NCSA). The NCSA can take one of three forms (at the option and agreement of the parties):

1. An amendment to the existing CSA between the parties. If this option is chosen, the existing CSA will be amended with respect to all transactions, both existing and future. Depending on what New Swap Margin Regulations-compliant terms are in the existing CSA, this option may be more or less attractive. In addition, this option may provide for netting of margin across both old and new transactions, which may not be possible with option 2 below. One concern is whether the amendment will “break” a nonstandard CSA; the amendment needs to be checked against your existing CSA to confirm that it can amended without creating problems.

2. Keep the existing CSA for existing transactions, and amend a duplicate of the existing CSA for new transactions. This has the advantage of preserving whatever was negotiated in the existing CSA for existing trades. It may not allow existing and future transactions to be netted for margin purposes, which may require the posting of additional collateral and may increase the price charged by your dealer. The same concerns as outlined above in 1 exist with respect to the amendment creating a “broken” CSA.

3. Replace your existing CSA with a brand new one (or if you did not have one before, now you do). The NCSA would apply to both existing and new transactions and may provide for netting across existing and new transactions. There would be no concerns regarding the creation of a “broken” CSA, but, if you had any negotiated provisions in your CSA that were New Swap Margin Regulations-compliant, they have now been lost.

Pepper Point

In addition to the three CSA options outlined above, the Questionnaire addresses a number of other options to be selected in the new (or amended) CSA, such as the minimum transfer amount, the determination of interest owed on posted collateral (including whether negative interest rates are possible) and whether substitute collateral types are permitted.

Regardless of which NCSA option is elected, if you have complicated swap documentation — for example a highly negotiated CSA bridged to your prime brokerage and futures accounts — you need to proceed carefully to ensure that everything still works after the substitution of the new or amended CSA.

Pepper Points

• The timing is tight for compliance with the New Swap Margin Regulations. If you are not compliant on March 1, 2017, your swap dealer will probably not let you enter into new swap transactions. That would be a very large problem for active traders, such as hedge funds.

• Similar rules are applicable in multiple jurisdictions, and swap users should consider whether their business activities, or the location of their swap dealers, may require the application of margin rules from other jurisdictions.

• The new paperwork required for compliance with the New Swap Margin Regulations is complicated and very detailed. It is important not to wait until the last minute to become compliant.

• We encourage those thinking about the New Swap Margin Regulations to speak with experienced regulatory counsel to discuss possible strategies for complying with the rule in greater detail. Pepper Hamilton can help.