Margin For Uncleared Swaps: A Critical Look At The CFTC And Prudential Regulators Proposals - Commodities/Derivatives/Stock Exchanges

Last fall both the Commodity Futures Trading Commission ("CFTC") and five U.S. prudential banking regulatorshere, we summarized the Proposals. In this Client Alert, we take a deeper look at the Proposals and highlight some of the many challenges that they would pose for market participants if implemented in their proposed form. ¹ (the "Prudential Regulators") released proposed rules for margin requirements for uncleared swap transactions for the entities subject to their regulation (the proposed rules of the CFTC, the "CFTC Proposal,"² the proposed rules of the Prudential Regulators, the "Prudential Regulators Proposal,"³ and the proposed rules, collectively, the "Proposals"). The margin requirements, when finalized, will play a significant role in determining the economics of the post-Dodd-Frank uncleared⁴ swaps market, including the extent to which market participants may favor or disfavor uncleared swaps in comparison with other types of transactions. In a previous Client Alert, available here, we summarized the Proposals. In this Client Alert, we take a deeper look at the Proposals and highlight some of the many challenges that they would pose for market participants if implemented in their proposed form.

Both the CFTC⁵ and the Prudential Regulators⁶ released proposals for margin in 2011. Since that time, however, there has grown an international consensus around the policy framework for margin stated in a series of papers released by the Basel Committee on Banking Supervision and the Board of the International Organization of Securities Commissions, the last of which was published in September, 2013 (the "BCBS/IOSCO Framework").⁷ With some significant exceptions, which we note below, the Proposals are broadly consistent both with the BCBS/IOSCO Framework and with each other.

I. OVERVIEW OF PROPOSALS AND ISSUES ARISING FROM THEM

Although the Proposals by their terms apply directly to "covered swap entities" (each, a "CSE"),⁸ the measures that they would require of CSEs would significantly change the economics of the uncleared swaps market not only for CSEs, but also for many of their financial counterparties. Among other things, the Proposals would:

require CSEs to bilaterally exchange initial margin with other CSEs and with a broad range of financial end users whose use of swaps met a notional amount-based threshold ("material swaps exposure"), all such initial margin to be segregated and not subject to rehypothecation or other use;

require CSEs to exchange variation margin with CSEs and with a broad array of financial end users (without regard to the existence of material swaps exposure);

permit the calculation of initial margin by means of either a model-based method or a table-based method;

permit offsets in relation to either initial margin calculations or variation margin calculations when (among other things) the offsets related to swaps that were subject to the same "eligible master netting agreement";

require the use of cash as variation margin; and

provide for staggered compliance dates ending in 2019 for initial margin, and apply to swaps transacted prior to a relevant compliance date if such swaps were subject to the same eligible master netting agreement as swaps transacted after such compliance date.

Among the issues for market participants that arise under the Proposals are the following:

The Proposals would set the definition of "material swaps exposure," the aggregate notional amount at which initial margin requirements would become effective for financial end users, considerably lower than that suggested by the BCBS/IOSCO Framework. As a result, U.S. parties to swaps may be disadvantaged in comparison with non-U.S. market participants. See Part II.A.2 below.

Several of the provisions contained in the Proposals would require CSEs to aggregate notional amounts with their affiliates. The aggregation requirement would affect not only the key "material swaps exposure" definition, but also the definition of "initial margin threshold" (the amount of initial margin below which no transfer of initial margin is required), and the phase-in schedule for initial margin. Affiliation for these purposes would be defined to be as little as 25 percent ownership or control. Aggregation of notional amounts exposures across diverse entities would be difficult to accomplish and would likely require the implementation of new systems. See Parts II.A.2, II.A.3 and VI.A below.

The manner in which initial margin is proposed to be calculated may lead to misleadingly high calculations. The Proposals would require calculations based on an assumed close-out period of 10 business days, an assumed period expressly intended to disfavor uncleared swaps, and more prolonged than the period that most closeouts of uncleared swaps actually require. Further, the Proposals restrict the nature of the offsets available in initial margin calculations by requiring each swap to be placed in one category and not permitting offsets even of truly like exposures across such categories. See Part II.B.1 below.

The important definition of "eligible master netting agreement" contained in the Proposals, as well as the Proposals' requirement for custodial agreements for initial margin, would require CSEs to meet a poorly defined, but apparently heavy, due diligence burden. See Part II.B.3 below.

The Proposals' requirement that variation margin be provided in the form of cash could help push swaps market liquidity into other jurisdictions and require investment managers to liquidate securities, thus causing tracking errors. See Part III.C below.

The manner in which the Proposals may apply to pre-compliance date swaps would incentivize parties to negotiate new master netting agreements for new swaps and, thus, could increase risk rather than reduce it. See Part VI.B below.

II. INITIAL MARGIN REQUIREMENTS

Initial margin is intended to secure potential future exposure, that is, adverse changes in value that may arise during the period of time when a swap or group of swaps is being closed out.⁹ Initial margin is to be provided within one business day after a swap is transacted¹⁰ and is to augment the variation margin securing the current mark-to-market value of a swap or set of swaps. Outside of areas notable for their volatility (such as FX transactions, and especially exotic FX transactions), dealers have typically been hesitant to seek to impose on clients of demonstrable creditworthiness requirements for financial collateral beyond that reflecting current mark-to-market value. Under typical existing documentation for uncleared swaps published by the International Swaps and Derivatives Association, Inc. ("ISDA"), a requirement for collateral in excess of current mark-to-market value would likely be expressed as an "Independent Amount."¹¹

The Proposals, in a significant break from historical practices for uncleared swaps, but in accordance with the BCBS/IOSCO Framework¹² and clearinghouse practices for cleared swaps, would require CSEs to both collect initial margin from and provide initial margin to many financial counterparties. Specifically, the Proposals would require the exchange of initial margin when (i) the notional amount of the swaps of a non-CSE financial counterparty and its affiliates reached a specified threshold ("material swaps exposure"), (ii) the initial margin calculation for swaps between the parties and their affiliates exceeded a separate threshold (the "initial margin threshold amount"), and (iii) a transfer was required with a value exceeding a specified minimum transfer amount. The mathematical basis upon which the Proposals would require CSEs to calculate initial margin is expressly intended to disfavor uncleared swaps. Unlike Independent Amounts under the ISDA Credit Support Annex, which typically form part of a calculation of a single value for which one party must provide collateral to the other,¹³ initial margin for each applicable swap under the Proposals would be provided by each party to the other and segregated with an unaffiliated custodian.¹⁴

A. When Initial Margin is Required

Subject to an exposure threshold (the "initial margin threshold amount") and a minimum transfer amount, the CFTC Proposal would require each party to provide initial margin to the other party when the relevant swap was between (i) a CFTC CSE, and (ii) either a CSE or a "financial end user" with "material swaps exposure."¹⁵ Similarly, subject to the same exposure threshold and minimum transfer amount, the Prudential Regulators Proposal would require each party to provide initial margin to the other party when the relevant swap or security-based swap was between (i) a Prudential Regulator CSE, and (ii) either a CSE or a "financial end user" with "material swaps exposure."¹⁶ Accordingly, the only time when initial margin is not mandated¹⁷ is when a party to a swap with a CSE is either (i) an end user that is not a "financial end user" or (ii) a financial end user that does not have "material swaps exposure."

1. Definition of "Financial End User"

The Proposals define "financial end user" as a party that is not a CSE, but which does fall within one of the 13 categories of entities engaged primarily in financial activities.¹⁸ The categories are virtually identical in the CFTC Proposal and the Prudential Regulators Proposal. While the definition makes for notably dense reading, the categories can be summarized as follows:

a wide variety of banks and bank-like institutions, both domestic and foreign;

an entity that is state-licensed or registered as a credit or lending entity (other than entities registered or licensed solely on account of financing the entity's direct sales of goods or services to customers) or as a money services business;

a securities holding company, broker or dealer, investment adviser or registered investment company;

a private fund and certain investment company-like entities;

a commodity pool, a commodity pool operator, a commodity trading advisor, or futures commission merchant;

many employee benefit plans;

an insurance company;

an entity that is, or holds itself out as being, an entity or arrangement that raises money from investors primarily for the purpose of investing in loans, securities, swaps, funds or other assets for resale or other disposition or otherwise trading in loans, securities, swaps, funds or other assets;

a foreign entity that would constitute a financial end user if it were organized under the laws of the United States or any State thereof; and

any other entity that a relevant regulator determines should be treated as a financial end user.¹⁹

The "financial end user" definition expressly excludes from its scope sovereign entities,²⁰ multilateral development banks ²¹ the Bank for International Settlements, and a subset of financial entities that engage in swaps to hedge or mitigate commercial risks.²²

2. Definition of "Material Swaps Exposure"

Under the Proposals, an entity has "material swaps exposure" when it and its affiliates have an average daily aggregate notional amount of uncleared swap products (including swaps, security-based swaps, foreign exchange forwards and foreign exchange swaps²³), calculated on business days falling in June, July and August of the previous year, that exceeds $3 billion.²⁴

The regulators' proposed definition of "material swaps exposure" is proving controversial for several reasons. Equating materiality to an average aggregate notional amount of $3 billion is contrary to the BCBS/IOSCO Framework, which contains a far higher standard for materiality and, thus, would require initial margin for many fewer financial end users. In addition, market participants have expressed concern about the practicability of the requirement that exposure be measured at the corporate group level, across a party and its affiliates, especially in view of the Proposals' unusually loose definition of "affiliate." Further, it is not clear why the definition of material swaps exposure should take into account foreign exchange forwards and foreign exchange swaps, simple and often short-dated trades transacted in large quantities, which themselves are not subject to initial margin requirements.

a. Use of $3 Billion as Materiality Standard

The average notional amount that the regulators use to define materiality, $3 billion, is significantly lower than the average notional amount (€8 billion,²⁵ or, at the time at which the Proposals were released, approximately $11 billion²⁶) by which the BCBS/IOSCO Framework defines materiality. The European regulators, in their draft regulatory technical standards pursuant to the European Market Infrastructure Regulation (the "EMIR RTS"), have also proposed to adopt the €8 billion threshold.²⁷ The U.S. regulators' lower number, if adopted, would require many more financial end users to provide initial margin than would be the case under the BCBS/IOSCO Framework or the EMIR RTS.²⁸

The CFTC and the Prudential Regulators explain the substantial disparity between $3 billion and $11 billion by reference to what they believe to be the intention of international regulators. They state that the intent of the BCBS/IOSCO Framework is to require collection of initial margin when the amount exceeds the initial margin threshold amount ($65 million in the Proposals); and, based on a review of data for cleared swaps, which the regulators deem to entail less risk than bilateral swaps, the regulators believe that there are many "cases in which a financial end user would have a material swaps exposure level below $11 billion but would have a swap portfolio with an initial margin collection amount that significantly exceeds the proposed permitted initial margin threshold amount of $65 million."²⁹ The $3 billion number, multiplied by what the regulators claim to be the average initial margin rate in the cleared swaps market of 2.1 percent of gross notional amount,³⁰ equals $63 million, just short of the proposed $65 million initial margin threshold. Accordingly, the U.S. regulators took the "preliminary view" that $3 billion is an appropriate threshold to determine when a financial end user's swaps exposure is material and should require the exchange of initial margin.³¹

That the U.S. regulators have correctly ascertained the intent of the BCBS/IOSCO Framework is by no means clear. The BCBS/IOSCO Framework states both that (i) "[a]ll covered entities must exchange, on a bilateral basis, initial margin with a threshold not to exceed €50 million"³², and (ii) "there will be a minimum level of non-centrally cleared OTC derivatives activity (€8 billion in gross notional outstanding amounts) necessary for covered entities to be subject to initial margin requirements described in this paper."³³ The framework does not appear to recognize any tension that might exist between these two statements, and indeed appears to state them as independent requirements. In fact, it seems plain that the BCBS/IOSCO Framework adopted the $65 million initial margin threshold amount to alleviate liquidity concerns arising from initial margin requirements, not to determine which parties should be subject to initial margin requirements.³⁴

In any event, many market participants see peril in the possibility of a $3 billion materiality threshold for initial margin. Some have noted that, if the U.S. regulators were to adopt a different standard for "material swaps exposure" than is adopted in other countries, U.S. companies and their affiliates could be hamstrung in comparison with companies with no ties to the U.S.³⁵ Similarly, others view a common threshold for "material swaps exposure" as necessary for international harmonization,³⁶ and warn that a disparity between U.S. and non-U.S. definitions could contribute to further swaps market fragmentation.³⁷

b. Aggregating Exposures Among Affiliates

The Proposals define "material swaps exposure" as the aggregate notional amount of swaps not only of a particular entity, but also of its affiliates. As a result, under the Proposals, in order to determine whether "material swaps exposure" exists, financial end users would be required to determine the overall notional amount of both their swaps and those of their affiliates. In this regard, the definition is aligned with both the BCBS/IOSCO Framework and the EMIR RTS.

However, market participants have expressed significant concerns regarding the potential necessity of aggregating their notional amounts with those of their affiliates. Calculations of aggregated swaps exposures could prove difficult for financial end users and their affiliates to implement and could require expensive new reporting and tracking systems.³⁹ Further, requiring financial end users to aggregate transactions of their non-financial affiliates could potentially penalize financial end users with relatively little swaps trading activity.⁴⁰

The difficulties that enterprises might have in tracking notional amounts across entities would likely be exacerbated by the unusually low level of "control" that the Proposals would require for an affiliation to exist. The "control" necessary for a company to be an "affiliate" of another company is defined loosely, as (a) only 25 percent (not 50 percent or more) of the ownership or control, directly or indirectly, of (i) a class of voting securities or (ii) the total equity, directly or indirectly, or (b) control in any manner of the election of a majority of the directors or trustees of the company.⁴¹ This definition of "control" means that entities with relatively low levels of affiliation would, under the Proposals, be required to work together to determine the notional amounts of their swaps.

Implementing the aggregation of notional amounts across affiliates, as so defined, could pose particular difficulties in the context of investment vehicles and asset management. For example, a large institutional investor such as a pension plan might own more than 25 percent of an investment vehicle and, thus, be required to aggregate the positions of the investment vehicle with its own swaps to determine overall swaps exposure.⁴² Moreover, aggregation of all of an investor's swaps appears to be incongruent with the typical practice, in the asset management context, of separating assets into different pools managed by different managers, with recourse of any counterparty limited to the particular assets in relation to which the manager has entered into a swap.⁴³ Accordingly, some have argued, investment funds and certain other investment vehicles should be exempted from any aggregation requirement.⁴⁴

c. Inclusion of FX Transactions in Determination of "Material Swaps Exposure"

The notional amounts used to calculate whether a party has "material swaps exposure" include the notional amounts of simple foreign exchange transactions—foreign exchange forwards and foreign exchange swaps⁴⁵—that do not qualify as "swaps" for many purposes and for which no initial margin is required.⁴⁶ The inclusion of such forwards and swaps in such calculation is in accordance with the BCBS/IOSCO Framework.⁴⁷

However, market participants have commented that requiring foreign exchange forwards and foreign exchange swaps to be aggregated for purposes of determining the existence of material swaps exposure would unduly increase costs for counterparties who use such products heavily, but use other derivatives only sparingly.⁴⁸ It is not wholly clear why such products, which are often short-dated, and which do not themselves require any initial margin, should be aggregated for purposes of determining whether material swaps exposure exists.⁴⁹

3. Initial Margin Threshold Amount and Minimum Transfer Amount

The posting of initial margin is subject to an "initial margin threshold amount" of $65 million, which, in accordance with the BCBS/IOSCO Framework,⁵⁰ is to apply on a consolidated entity level, across each party and its affiliates in respect of all uncleared swaps and security-based swaps.⁵¹ The initial margin threshold amount reduces any initial margin that is required to be posted by a party. If the initial margin requirement is less than the initial margin threshold amount, then there is no requirement to post initial margin.⁵²

The application of the threshold amount across each party and its affiliates raises similar concerns as does the aggregation of swaps exposures across affiliates for purposes of "material swaps exposure" (see Part II.A.2.b above). Especially in view of the low 25 percent requirement for affiliation, the application of the initial margin threshold amount across all affiliates would, in practice, likely prove difficult and costly to implement.⁵³

Under both Proposals a CSE is not required to collect or post any amount below the minimum transfer amount of USD $650,000.⁵⁴

B. Calculation of Initial Margin

Under both Proposals, a CSE must calculate the required amount of initial margin daily, on the basis of either a risk-based model or a table-based method.⁵⁵ The regulatory requirements for risk-based models are significant.

In relation to risk-based models, market participants have noted several aspects of the calculation of initial margin in the Proposals that could prove disadvantageous or problematic. The Proposals would require models to calculate initial margin amounts on the basis of a 10-day close-out period, a hypothetical period that is expressly intended to disfavor uncleared transactions and is longer than the period that actual close-outs typically require under standard documentation for uncleared swaps. In addition, the Proposals would limit, arguably artificially, the extent to which initial margin models would be permitted to reflect offsetting exposures.

Of relevance to both risk-based models and the table-based method is the regulators' definition of "eligible master netting agreement," which would place an ill-defined, but potentially heavy, burden of due diligence on CSEs, who would be required to verify the treatment of netting agreements under all relevant insolvency regimes.

1. Risk-Based Model

The regulators' requirements for risk-based models include the following.

a. Ten Business Day Close-Out Period

Under both Proposals, a risk-based model used by a CSE would generally calculate initial margin based on the assumption of a "holding period" of 10 business days.⁵⁶ This is the period for which the initial margin required by the Proposals would be intended to mitigate risk, which, in theory, at least, should correspond to the period when a swap or set of swaps is in the process of being closed out. The amount of initial margin would be calculated as an amount equal to an estimate, for that period, "of the one-tailed 99 percent confidence interval for an increase in the value... due to an instantaneous price shock that is equivalent to a movement in all material underlying risk factors, including prices, rates, and spreads."⁵⁷ A model-based method would be required to use "risk factors sufficient to measure all material price risks inherent in the transactions for which initial margin is being calculated."⁵⁸ The data used to calibrate the model would be based on an equally weighted historical observation period of at least one year and not more than five years and would incorporate a period of significant financial stress for each broad asset class related to the relevant swaps.⁵⁹

The assumed length of the close-out period is of critical importance to the calculation of initial margin; the longer the assumed close-out period, the greater the initial margin amount. The regulators' proposed ten-business-day liquidation horizon, which is longer than the 10-day horizon (apparently calendar days, not business days) contemplated by the BCBS/IOSCO Framework,⁶⁰ is expressly intended to disfavor uncleared swaps relative to cleared swaps. According to the CFTC Proposal, by requiring "ten day initial margins for uncleared swaps and only five day margin for cleared swaps," the Proposals "make cleared swaps relatively more attractive."⁶¹ This explanation, however, understates the extent of the regulators' favoritism of cleared swaps. Many cleared swaps, namely those on agricultural commodities, energy commodities, and metals, are permitted minimum liquidation times of only one day.⁶² Further, for cleared swaps, market participants can request,⁶³ and have requested,⁶⁴ that assumed close out periods be reduced.

A ten-business-day close-out period, moreover, appears to be materially longer than the usual close-out period for most uncleared swaps. A typical close-out period under an ISDA Master Agreement, the most-used master netting agreement in the uncleared swaps market, might reasonably be expected to require approximately four to six business days, a period that takes into account of the cure period, typically of one or three business days,⁶⁵ to cure a failure to pay or deliver, as well as the time required to deliver notices and value outstanding transactions. One CFTC Commissioner, in requesting a "considered analysis" of the effects of a ten-business-day period, stated that he was "troubled by recent press reports of remarks by unnamed Fed officials that the coverage period may be intentionally 'punitive' in order to move the majority of trades into a cleared environment."⁶⁶ Market participants have contended that the proposed ten-business-day liquidation time is too long for purposes of determining initial margin amounts, and should be shortened to closer to five days⁶⁷ or even shorter.⁶⁸

b. Restrictions on Use of Offsets in Calculations of Initial Margin

The Proposals restrict the extent to which a risk-based model may reflect offsetting exposures that would reduce the required amount of initial margin. A risk-based model for initial margin would be permitted to recognize an offsetting exposure for a swap only in relation to another swap that falls within the same category, and not in relation to another swap that falls within another category.⁶⁹

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Footnotes

1 The five prudential regulators include the Office of the Comptroller of the Currency, the Board of Governors of The Federal Reserve System, the Federal Deposit Insurance Corporation, the Farm Credit Administration and the Federal Housing Finance Authority.

2 Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 79 Fed. Reg. 59898 (October 3, 2014).

3 Margin and Capital Requirements for Covered Swap Entities, 79 Fed. Reg. 57348 (September 24, 2014).

4 The CFTC Proposal refers to swaps that are not centrally cleared as "uncleared swaps," while the Prudential Regulators Proposal refers to such swaps as "non-cleared swaps." For consistency, we refer to them as "uncleared swaps."

5 See Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 76 Fed. Reg. 23732 (April 28, 2011).

6 See Margin and Capital Requirements for Covered Swap Entities, 76 Fed. Reg. 27564 (May 11, 2011).

7 Basel Committee on Banking Supervision and Board of the International Organization of Securities Commissions, Margin requirements for non-centrally cleared derivatives (September 2013).

8 The Prudential Regulators Proposal, if finalized, would apply to "covered swap entities" including swap dealers (each, an "SD"), major swap participants (each, an "MSP"), security-based swap dealers and major security-based swap participants, in each case that is regulated by one of the Prudential Regulators. Prudential Regulators Proposal at 57350. The CFTC Proposal, if finalized, would apply to SDs and MSPs for which there is no Prudential Regulator. CFTC Proposal at 59902. We refer to "covered swap entities" as "CSEs" unless the context requires differentiation between CSEs for purposes of the CFTC Proposal and CSEs for purposes of the Prudential Regulators Proposal, in which case we refer to the CSEs covered by the Prudential Regulators Proposal as "Prudential Regulator CSEs" and to the CSEs covered by the CFTC Proposal as "CFTC CSEs."

9 See, e.g., CFTC Proposal at 59901.

10 CFTC Proposed Rule 23.152; Prudential Regulators Proposed Rule ___.3(c).

11 See the preprinted form of Credit Support Annex, published in 1994 by ISDA (the "ISDA Credit Support Annex"), at paragraph 12 (defining "Independent Amount") and paragraph 3 (stating how Independent Amounts are to be used in calculations of collateral required to be exchanged).

12 BCBS/IOSCO Framework at 4, 18-21.

13 See ISDA Credit Support Annex at paragraph 3.

14 See CFTC Proposed Rule 23.157; Prudential Regulators Proposed Rule ___.7.

15 CFTC Proposed Rules 23.152 and 23.151 (definition of "Covered counterparty").

16 Prudential Regulators Proposed Rule ___.3.

17 See discussion of non-financial end users below at Part IV.

18 See CFTC Proposed Rule 23.151 (definition of "Financial end user"); Prudential Regulators Proposed Rule ___.2 (definition of "Financial end user").

19 See id.

20 Sovereign entities are defined in the Proposals as a central government (including the U.S. government) or an agency, department, ministry, or central bank of a central government. See CFTC Proposed Rule 23.151 (definition of "sovereign entity"); Prudential Regulators Proposed Rule ___.2 (definition of "sovereign entity").

21 The Proposals define the term multilateral development bank as the International Bank for Reconstruction and Development, the Multilateral Investment Guarantee Agency, the International Finance Corporation, the Inter-American Development Bank, the Asian Development Bank, the African Development Bank, the European Bank for Reconstruction and Development, the European Investment Bank, the European Investment Fund, the Nordic Investment Bank, the Caribbean Development Bank, the Islamic Development Bank, the Council of Europe Development Bank, and any other entity that provides financing for national or regional development in which the U.S. government is a shareholder or contributing member or which the relevant Prudential Regulator or the CFTC determines poses comparable credit risk. See CFTC Proposed Rule 23.151 (definition of "Multilateral development bank"); Prudential Regulatory Proposed Rule ___.2 (definition of "Multilateral development bank") .

22 See CFTC Proposed Rule 23.151 (definition of "Financial end user"); Prudential Regulator Proposed Rule __.2 (definition of "Financial end user").

23 For these purposes, "foreign exchange forward" is defined as a transaction that solely involves the exchange of two different currencies on a specific future date at a fixed rate agreed upon on the inception of the contract covering the exchange, and "foreign exchange swap" is defined as a transaction that solely involves an exchange of two different currencies on a specific date at a fixed rate that is agreed upon on the inception of the contract covering the exchange and a reverse exchange of those two currencies at a later date and at a fixed rate that is agreed upon on the inception of the contract covering the exchange. See Commodity Exchange Act, 7 U.S.C. 1, et seq., at Section 1a(24) and 1a(25). See also CFTC Proposed Rule 23.151 (definition of "Foreign exchange forward and foreign exchange swap"; Prudential Regulator Proposed Rule ___.2 (definition of "Foreign exchange forward and foreign exchange swap"). Because they settle by means of cross-exchanges of currencies rather than a single settlement payment from one party to another, foreign exchange forwards and foreign exchange swaps are also known as "physically settled" foreign exchange forwards and foreign exchange swaps.

24 CFTC Proposed Rule 23.151 (definition of "Material swaps exposure"); Prudential Regulators Proposed Rule ___.2 (definition of "Material swaps exposure").

25 BCBS/IOSCO Framework at 8, 24.

26 See CFTC Proposal at 59905. However, at current exchange rates €8 billion is equal to approximately $9 billion, not $11 billion. Both the initial margin threshold amount ($65 million in the Proposals and €50 million in the BCBS/IOSCO Framework) and the minimum transfer amount ($650,000 in the Proposals and €500,000 million in the BCBS/IOSCO Framework) are based on an assumed exchange rate of 1.30 U.S. dollars to 1 Euro. However, at current exchange rates, the dollar equivalents of the initial margin threshold amount and minimum transfer amount stated in the BCBS/IOSCO are significantly lower than $65 million and $650,000. In the Proposals, the regulators request comment on whether and how fluctuations resulting from exchange rate movements should be addressed. See CFTC Proposal at 59901; Prudential Regulators Proposal at 57353.

27 Consultation Paper – Draft regulatory technical standards on risk-mitigation techniques for OTC-derivatives contracts not cleared by a CCP under Article 11(15) of Regulation (EU) No 648/2012, April 14, 2014, at 5, 7.

28 Another disparity between the approach of non-U.S. regulators and that of the CFTC and Prudential Regulators relates to the days on which the calculation for "materials swaps exposure" takes place. Under both of the Proposals, the existence of "material swaps exposure" is to be determined based on the average notional amounts calculated on business days falling in June, July and August of the previous year. See CFTC Proposed Rule 23.151 (definition of "Material swaps exposure"); Prudential Regulators Proposed Rule ___.2 (definition of "Material swaps exposure"). In contrast, under the BCBS/IOSCO Framework, notional amounts are to be determined based on the average notional amounts calculated at the end of each of June, July and August. BCBS/IOSCO Framework at 23-24. See also EMIR RTS at 46.

29 CFTC Proposal, 79 Fed. Reg. at 59905; Prudential Regulators Proposal, 79 Fed. Reg. at 57367.

30 See id.

31 CFTC Proposal, 79 Fed. Reg. at 59905; Prudential Regulators Proposal, 79 Fed. Reg. at 57366-67.

32 See note 26 above and discussion at Part II.A.3.

33 BCBS/IOSCO Framework at 9.

34 See BCBS/IOSCO Framework at 8 ("One method for managing the liquidity impact associated with initial margin requirements—and one that has received broad support—is to provide for an initial margin threshold (threshold) that would specify an amount under which a firm would have the option of not collecting initial margin."); comment letter of the Investment Company Institute, dated September 24, 2014 (the "ICI Letter"), at 7, note 15.

35 See, e.g., comment letter of the Asset Management Group of the Securities Industry and Financial Markets Association, dated November 24, 2014, (the "SIFMA Letter") at 12.

36 ICI Letter at 7.

37 Comment letter of the Coalition for Derivatives End-Users, dated December 2, 2014, at 8.

38 BCBS/IOSCO Framework at 10, 24; EMIR RTS at 46.

39 SIFMA Letter at 7.

40 Comment letter of the Committee on Investment of Employee Benefit Assets, dated November 24, 2014 (the "CIEBA Letter"), at 9-10.

41 See CFTC Proposed Rule 23.151 (definitions of "Affiliate" and "Control"); Prudential Regulators Proposed Rule ___.2 (definitions of "Affiliate" and "Control").

42 See CIEBA Letter at 6; SIFMA letter at 7.

43 SIFMA Letter at 9.

44 SIFMA Letter at 8. See also ICI Letter at 9-10.

45 See note 23 above.

46 The Proposals do not contain margin requirements for foreign exchange forwards and foreign exchange swaps, in keeping with the Secretary of the Treasury's determination to exempt such transactions from most provisions of the Commodity Exchange Act, including margin requirements. See Determination of Foreign Exchange Swaps and Foreign Exchange Forwards Under the Commodity Exchange Act, 77 Fed. Reg. 69694 (November 20, 2012). See also Part III.D below.

47 BCBS/IOSCO Framework at 24.

48 SIFMA Letter at 14-15; CIEBA Letter at 12-13.

49 See CIEBA Letter at 13.

50 See BCBS IOSCO Framework at 9.

51 See CFTC Proposed Rule 23.151 (definition of "Initial margin threshold amount"); Prudential Regulators Proposed Rule ___.2 (definition of "Initial margin threshold amount").

52 See CFTC Proposed Rule 23.154(a); Prudential Regulators Proposed Rule ___.3(a).

53 SIFMA Letter at 7.

54 See CFTC Proposed Rule 23.151 (definition of "Minimum transfer amount"); Prudential Regulators Proposed Rule ___.5(a).

55 See CFTC Proposed Rule 23.154(a); Prudential Regulators Proposed Rule ___.3 and Proposed Rule ___.2 (definition of "Initial margin collection amount").

56 CFTC Proposal at 23.154(b)(3)(i); Prudential Regulators Proposal at __.8(d)(1).

57 CFTC Proposal at 23.154(b)(3)(i); Prudential Regulators Proposal at __.8(d)(1).

58 CFTC Proposal at 23.154(b)(3)(iii); Prudential Regulators Proposal at __.8(d)(3).

59 CFTC Proposal at 23.154(b)(3)(ii); Prudential Regulators Proposal at __.8(d)(2).

60 BCBS/IOSCO Framework at 11.

61 CFTC Proposal at 59924.

62 CFTC Rule 39.13(g)(2)(ii)(B).

63 See CFTC Rule 39.13(g)(2)(ii)(D).

64 See, e.g., letter to CFTC of Javelin SEF, LLC, dated December 3, 2014, requesting that the minimum liquidation time for certain interest rate swaps be shortened from five days to one day.

65 The 2002 version of the ISDA Master Agreement provides a one-business-day cure period for an event of default based on a failure to make a required payment or delivery. See ISDA 2002 Master Agreement at Section 5(a)(i). The 1992 version of the ISDA Master Agreement provides a three-business-day cure period for an event of default based on a failure to make a required payment or delivery. See ISDA Master Agreement (Multicurrency—Cross-Border) at Section 5(a)(i). The parties to such an agreement may agree to amend any applicable cure period.

66 CFTC Proposal at 59934-35 (Appendix 3—Statement of Commissioner J. Christopher Giancarlo).

67 SIFMA Letter at 28.

68 CIEBA Letter at 14.

69 CFTC Proposal at 23.154(b)(3)(v); Prudential Regulators Proposal at __.8(d)(5).

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

United States: Margin For Uncleared Swaps: A Critical Look At The CFTC And Prudential Regulators Proposals