United States: Financial Entity Update - CFTC's Proposed Margin Rules For Uncleared Swaps – Dude, Where's My Collateral?

Last Updated: September 22 2015
Article by Bo Harvey and John S. Servidio

This is the third article in a series on the U.S. Commodity Futures Trading Commission's (CFTC's) proposed margin rules for uncleared swaps, with a particular focus on the rules as they relate to swap market participants that are neither swap dealers nor commercial end users.

In our first installment on the CFTC's proposed margin rules (Margin Rules) for uncleared swaps, we discussed the importance of applying the "financial end user" definition and making related notional calculations. In our second installment we discussed collateral requirements, timing, eligibility and haircuts. In this issue we move on to custody and segregation of initial margin and related documentation requirements.

Custodial Arrangements for Initial Margin

Under the Margin Rules, covered swap entities (CSEs) would be required to exchange initial margin with financial end users that have "material swaps exposure." (For a refresh on the definitions of CSE, financial end user and material swaps exposure, please see our prior update.) In general, the initial margin posted or collected by a CSE must be held by one or more custodians that are unaffiliated with either the CSE or its counterparty. In addition, the agreement among the CSE, its counterparty and the custodian must meet certain requirements. CFTC Rule 23.157 specifies that the custody agreement: (1) must prohibit the custodian from rehypothecating or otherwise transferring the initial margin it holds; (2) may, notwithstanding the prohibition on rehypothecation, permit the posting party to substitute or direct reinvestment of initial margin held by the custodian, provided all assets remain eligible as initial margin and of sufficient value; and (3) must be legal, valid, binding and enforceable under the laws of all relevant jurisdictions, including in the event of bankruptcy, insolvency or a similar proceeding.

While these requirements may appear straightforward, they pose the following important considerations for financial end users.

Mandatory Segregation for Certain Financial End Users

CFTC Rule 23.701 requires that swap dealers notify their counterparties of their right to elect segregation of initial margin at an unaffiliated custodian. The Margin Rules would turn the current election to segregate initial margin into a mandatory requirement for financial end users that have material swaps exposure. As a result, financial end users with material swaps exposure will no longer be able to opt out of initial margin segregation when they trade uncleared swaps with CSEs. CSEs and financial end users subject to this requirement will need to review their custodians and triparty custody agreements to confirm that (1) the custodian is unaffiliated with either party, (2) rehypothecation is prohibited and (3) the custody agreement is enforceable under the laws of all relevant jurisdictions.

Financial end users without material swaps exposure are not required to post initial margin under the Margin Rules. As such, they would still retain the option, but not the requirement, to segregate initial margin under CFTC Rule 23.701. To the extent these financial end users exercise this right, they would not be required to segregate initial margin posted to a CSE because the Margin Rules apply the segregation requirement only to initial margin that is required to be collected by a CSE.

Know Your Custodians

Financial end users that trade with many CSEs or use multiple custodians will need to determine whether any particular transaction is in compliance with the requirement to use an unaffiliated custodian. For instance, asset managers that use global custodial arrangements on behalf of multiple clients may need to take a fresh look at whether existing custodial arrangements can continue to be used or new arrangements for certain client-CSE pairs will need to be implemented. The requirement to use an unaffiliated custodian may also pose a problem for pension plans that use their trustees, or affiliates of their trustees, as custodians. It is also unclear how, or whether, this requirement would apply to sub-custodians. If it does, custodians will need to track and monitor the affiliations of their sub-custodians with respect to specific CSE-financial end user pairs.

More generally, given the limited number of large custodians, there are also concerns that the non-affiliation requirement will serve to further increase market concentration in the custody services industry and will put pressure on custodial capacity.

Standards for Custody Agreements

The condition that the custody agreement must be "legal, valid, binding and enforceable under the laws of all relevant jurisdictions including in the event of bankruptcy, insolvency, or a similar proceeding" gives rise to the following challenges.

First, it may be difficult to identify all the "relevant jurisdictions" for the purpose of the enforceability analysis. The organizational structures through which CSEs, financial end users and custodians (and their sub-custodians) exchange and hold margin may implicate several relevant jurisdictions.

Second, it is unclear what level of review suffices for determining that the agreement is enforceable. If legal opinions are required, what type of qualifications would be permitted? It may not be possible to obtain unqualified opinions in all circumstances or jurisdictions. Obtaining any required opinions – perhaps for multiple jurisdictions – will also add a significant cost and expense to implementing initial margin segregation.

Third, it is not clear what exactly the phrase "including in the event of bankruptcy" refers to. One possible interpretation is that the custodial agreement is generally enforceable notwithstanding the bankruptcy of any party, but that interpretation is dissonant with equitable principles of U.S. bankruptcy law, as contracts are generally subject to the insolvency of a party unless there is a specific exemption under the Bankruptcy Code, such as the safe harbor that protects the netting of qualified financial contracts. It is possible that the CFTC's intention was that "in the event of bankruptcy" referred to the custodian's bankruptcy, but this is not clear from the proposed rule.

Prime Brokerage Transactions

Under the Margin Rules, the custodian is not permitted to rehypothecate initial margin it holds, although the posting party is permitted to substitute or direct reinvestment of initial margin held by the custodian, provided all assets remain eligible as initial margin and of sufficient value. There is some confusion as to how the prohibition on rehypothecation will affect intermediated prime brokerage transactions. In these transactions, a client, typically an asset manager, will enter into a trade with an executing dealer, which then "gives up" the swap to client's prime broker, which may be a CSE. The parties are left with a trade between the client and its prime broker and a substantially equal and offsetting trade between the prime broker and the executing dealer. The prime broker is principal to both legs of the transaction: one facing the client and the other facing the executing dealer. The prime broker effectively transfers initial margin it receives from one party to satisfy the demand for initial margin from the other party. Under the Margin Rules it is unclear whether this would constitute an unpermitted rehypothecation. Without allowing for these arrangements, intermediate prime brokerage transactions may no longer be economically viable for many prime brokers that are also CSEs.

Margin Documentation

The Margin Rules also require that CSEs enter into documentation with counterparties that satisfies the swap trading relationship documentation (STRD) requirements under CFTC Rule 23.504 and provides for the exchange of any margin required by the Margin Rules. While most CSEs and their counterparties have already adhered to the ISDA March 2013 Dodd-Frank Protocol designed to comply with the STRD rules, Rule 23.158 of the Margin Rules may require additional documentation between CSEs and non-financial end users in order to document whether margin is to be exchanged (even if such margin is not required) and, if so, the methodology and data sources for calculating margin, the valuation of positions and margin, dispute resolution and applicable thresholds below which margin is not required.

With respect to valuation and dispute resolution, the Margin Rules contain inconsistencies with other CFTC rules. For instance, CFTC Rule 23.504 requires swap documentation to include "methods, procedures, rules and inputs" for swap valuation and a dispute resolution process, and CFTC Rule 23.431(d)(3) requires disclosure of "the methodology and assumptions used to prepare the daily mark" for each uncleared swap. When the Margin Rules are finalized, CSEs and financial end users will need to review their swap documentation and credit support annexes to determine if they satisfy the proposed documentation requirements.

Next Steps

In our next installment in the series, we will discuss the calculation and netting of margin.

Once the Margin Rules are finalized, they will create a project with economic and operational complexity for many financial end users, to say nothing of particular cross-border differences that will need to be navigated. Please contact one of the authors or your regular McGuireWoods lawyer if you have questions about how margin requirements may apply to your business.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Similar Articles
Relevancy Powered by MondaqAI
Cadwalader, Wickersham & Taft LLP
 
In association with
Related Topics
 
Similar Articles
Relevancy Powered by MondaqAI
Cadwalader, Wickersham & Taft LLP
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions