Eileen Bannon is a Partner in the New York office
- March 1, 2017 is the scheduled implementation date applicable for most financial end users for the mandatory posting of variation margin to their swap dealer counterparties under U.S. margin rules.
- In most cases, the U.S. margin rules will require swap dealers to amend their existing collateral support documentation with financial end users or enter into new collateral support documentation.
- This guide is designed to assist financial end users in understanding the regulatory requirements, the elections they will have to make and the outcomes under standard industry documentation.
The scheduled implementation date applicable for most financial end users for the mandatory posting of variation margin to their swap dealer counterparties under U.S. margin rules is March 1, 2017. In most cases, the U.S. margin rules will require swap dealers to amend their existing collateral support documentation with financial end users or enter into new collateral support documentation. Although the obligation to enter into regulation compliant documentation falls on swap dealers, financial end users will not be permitted to trade under collateral support documentation that is not regulation compliant after March 1, 2017. The documentation process will require financial end users to make complicated elections.
The following guide outlines the regulatory requirements and the elections financial end users will be required to make, and also addresses the options available to them with respect to entering into new documentation or revising existing documentation to ensure compliance with U.S. margin rules.
On Oct. 22, 2015, U.S. prudential regulators with supervisory authority over certain swap dealers, security-based swap dealers, major swap participants and major security-based swap participants issued a final rule adopting initial and variation margin requirements with respect to uncleared swaps.1 On Dec. 16, 2015, the Commodity Futures Trading Commission (CFTC) issued a substantially similar final rule adopting initial and variation margin requirements for swap dealers and major swap participants subject to its jurisdiction that are not supervised by one of the prudential regulators (collectively with the prudential regulator margin rule, the U.S. margin rules).
The U.S. margin rules, among other things, require swap dealers, security-based swap dealers, major swap participants and major security-based swap participants subject to such rules (collectively, Covered Entities) to collect and post variation margin in connection with uncleared swaps and uncleared security-based swaps entered into with "financial end users," as defined in the U.S. margin rules.2 The scheduled implementation date of the U.S. margin rules with respect to variation margin rules in connection with financial end users3 is March 1, 2017 (the Effective Date).
Margin regulations also have been adopted for Canada and Japan, with a general market variation margin compliance date of March 1, 2017. European and Swiss margin rules have been delayed, but also are expected to have a general market variation margin compliance date of March 1, 2017.
The U.S. margin rules require Covered Entities to execute documentation with counterparties providing for the exchange of initial and variation margin on a net basis, specifying the methods and including the inputs for determining the value of the swaps for the purpose of calculating initial and variation margin, providing for same-day transfer of margin and specifying the method of resolution of disputes concerning valuation of swaps or collateral.
This guide addresses the options potentially available to financial end users with respect to entering into new documentation or revising existing documentation to make it compliant with the U.S. margin rules with respect to the posting and collection of variation margin.4
III. Industry Response
The International Swaps and Derivatives Association (ISDA) has responded to the need for variation margin documentation compliant with the U.S. margin rules by issuing a new credit support document, the 2016 Credit Support Annex for Variation Margin (VM) New York Law (the 2016 VM CSA).5 In addition, in order to accommodate the "big bang" simultaneous implementation of the variation margin rules of the several regulatory regimes on March 1, 2017, ISDA has developed an ISDA 2016 Variation Margin Protocol (the VM Protocol). The VM Protocol is designed to provide a mechanism for adherents to match with their respective counterparties in all applicable regulatory regimes, and amend or enter into new documentation on a multilateral basis.
As with prior ISDA protocols, ISDA has partnered with IHS Markit to provide a functionality, referred to as ISDA Amend, to allow market participants to adhere online to the VM Protocol. ISDA also has published a Regulatory Margin Self Disclosure Letter designed to inform entities with the obligation to post and collect margin under the margin regimes of the U.S., the EU, Canada, Japan or Switzerland, with the characteristics of their counterparties for the purpose of making determinations as to regulatory margin requirements. The ISDA Amend process envisions that adherents to the VM Protocol will have provided necessary information to their counterparties pursuant to the Regulatory Margin Self Disclosure Letter by means of ISDA Amend prior to adhering to the VM Protocol.
As of the date of this guide, the VM Protocol provides a process for putting into place regulation compliant documentation for parties subject to Japanese, Canadian, EU and U.S. margin regimes (each a Covered Margin Regime).
The VM Protocol is designed to be supplemented to include additional margin regulations as Covered Margin Regimes.
IV. Financial End User Decisions to Achieve Documentation Compliant with U.S. Margin Rules
A. Under what circumstances will collateral support documentation compliant with the U.S. margin regulations be required?
If a financial end user does not intend to enter into a new transaction (or materially amend an existing transaction) under an existing ISDA Master Agreement on or after the Effective Date, it does not need to amend or replace its existing collateral support document with respect to that ISDA Master Agreement.
If a financial end user does intend to enter into one or more new transactions (or materially amend one or more existing transactions) under an existing ISDA Master Agreement on or after the Effective Date, its collateral support documentation for such ISDA Master Agreement will need to be compliant with the U.S. margin regulations.
B. What are the principal modifications to be made to collateral support documentation to be compliant with the U.S. margin regulations?
- The U.S. margin rules provide that initial margin and variation margin obligations may not be netted against each other. Accordingly, if a financial end user's existing collateral support document provides for such netting, an amendment of such provision is required. On the other hand, if the existing collateral support document provides that neither party is required to post initial margin, and the parties will not be required to post initial margin under the U.S. margin rules, no amendment of such provision is required.
- The timing of posting of variation margin under the U.S. margin rules may be shorter than the parties have provided under existing collateral support documentation. Under the U.S. margin rules, if a demand for transfer of eligible collateral is made by the notification time, the transfer of collateral is required on the same local business day, and if the demand for transfer of eligible collateral is made after the notification time, the transfer of collateral is required on the next local business day.6
- Eligible collateral under the U.S. margin rules includes: U.S. dollars, the currency of settlement of the swap, certain specified major currencies, U.S. Treasury securities, other securities guaranteed by the full faith and credit of the U.S. government, certain sovereign securities, certain publicly issued debt securities having the benefit of U.S. government support, the debt of the Bank for International Settlement, the International Monetary Fund or a multilateral development bank, publicly-traded debt that has been deemed acceptable by a prudential regulator, certain publicly traded equity, certain redeemable securities in a pooled investment fund and gold. All of the foregoing are subject to specified haircuts, except for U.S. dollars or another major currency and cash in the same currency as the settlement of the swap.
- The U.S. margin rules eliminate the concept of variation margin threshold and, instead, establish a minimum transfer amount of $500,000 applicable collectively to initial margin and variation margin.
After reviewing its existing collateral support documentation against the U.S. margin rules, a financial end user may determine that it is possible to amend such credit support documentation in a surgical fashion, e.g., by changing transfer timing or amending the definition of eligible collateral. A more extensive modification may be necessary, if, for example, the collateral support provides for the posting of initial margin.
The financial end user also will need to decide whether to do one of the following:
- amend its existing collateral support document so that the changes are applicable to all transactions under the ISDA Master Agreement (including those entered into prior to the Effective Date)
- retain its existing collateral support document without amendment for transactions entered into prior to the Effective Date, and into a second collateral support document under the same ISDA Master Agreement, applicable only to transactions entered into on and after the Effective Date
If a financial end user chooses the first option, it will have determined to have one "netting portfolio," and all transactions under the ISDA Master Agreement will be netted for the purpose of determining variation margin (and initial margin, if applicable). If a financial end user chooses the second option, it will have determined that the transactions subject to each of such two collateral support documents form two separate netting portfolios under the same ISDA Master Agreement, requiring separate determinations and postings of variation margin (and initial margin, if applicable).
C. What are the options for a collateral support document which is compliant with the U.S. margin rules?
1. Bespoke Documentation; 2016 VM CSA
For some market participants for which required documentation changes are not extensive, a bilateral amendment to existing documentation may make the most sense. As discussed above, the parties could either amend the existing collateral support document, or could enter into an additional collateral support document exclusively for post-Effective Date transactions under the same ISDA Master Agreement. A new collateral support document could take the form of a replication of the existing collateral support document, with only such changes as are necessary to reflect implementation of the U.S. margin rules. Alternatively, a new credit support document could be documented under the 2016 VM CSA.
A caveat to a bilaterally negotiated solution is that, although it may be the most straightforward approach from the point of the financial end user, it may be difficult for the related Covered Entity to accomplish before the Effective Date. If this is the approach that a financial end user would like to take, it is advisable for the financial end user to contact its respective counterparties well in advance of the Effective Date or the date it wants to trade under the related collateral support documentation, if later.
If a financial end user is to amend its existing collateral document or replicate its existing collateral document and amend it to be compliant with the U.S. margin rules, such amendments should include, at a minimum:
- if a new collateral support document, specification of the scope of the transactions covered under the new collateral document and the non-overlapping set of those transactions covered under the prior collateral support document
- if a new collateral support document, the new collateral document should provide for certain set off and netting rights7
- amendment of eligible collateral provisions, including haircuts, as necessary
- specification of the notification time and the transfer timing noted above
- elimination of any VM thresholds and modification of the minimum transfer amount, as necessary
If parties determine to enter into a second collateral support document, they may find it most convenient to do so by entering into a 2016 VM CSA. In addition to accomplishing all the amendments discussed above, the 2016 VM CSA includes several provisions not mandated by the U.S. margin rules that financial end users may find useful and Covered Entities may require.
The 2016 VM CSA includes the following additional provisions:
- an update to the dispute resolution procedures to conform to the form of 2002 ISDA Master Agreement
- provision for an elective treatment of negative interest
- provision for an elective inclusion of daily interest compounding
- an election with respect to the treatment of the interest
accrued on VM:
- Interest Transfer: the interest amount due on VM is transferred to the interest payee (with the option to set off delivery or return amounts due to the interest payor on the same date), or
- Interest Adjustment: the interest amount due constitutes an adjustment to the posted collateral (VM) held by the secured party
- amendment of Section 11 to give the secured party the right to send the pledgor notice that it has determined that one or more items of eligible credit support no longer satisfies, or will no longer satisfy, eligibility requirements under applicable law and thereafter will have a value of zero
2. Entry into the VM Protocol
As with the prior ISDA protocols, the VM Protocol provides a mechanism for a party to enter into compliant documentation with multiple counterparties. In addition, the VM Protocol is designed to put in place documentation with counterparties across multiple Covered Margin Regimes. Most importantly, where a Covered Entity is subject to more than one Covered Margin Regime, the VM Protocol, by specifying provisions that are the most restrictive of the applicable regimes, provides collateral support documentation that is compliant with all of such regimes. Accordingly, if a financial end user has swap relationships with Covered Entities subject to multiple Covered Margin Regimes, the financial end user may determine that the VM Protocol is the preferable alternative. It is also likely that certain Covered Entities will expect financial end users to enter into compliant documentation by means of the VM Protocol.
Capitalized terms used hereinafter in this guide, unless otherwise defined, have the respective meanings assigned thereto in the VM Protocol.
V. How to Navigate the VM Protocol
As with prior ISDA protocols, adherence to the VM Protocol is a two-step process. First, a party must deliver an Adherence Letter to ISDA and then exchange Questionnaires with counterparties to amend or create new collateral support documentation. The architecture for the VM Protocol with respect to the U.S. margin rules is also familiar and includes: (i) the ISDA 2016 Variation Margin Protocol, (ii) the ISDA 2016 Variation Margin Protocol Questionnaire and (iii) two forms of Exhibits to be selected as described below.
A. Election of Amend, Replicate-and-Amend or New CSA
Unlike prior Protocols, the VM Protocol provides that the parties must match with respect to certain elections as a condition precedent. Certain combinations of elections by the parties, as discussed below, will result in Matched Questionnaires, and the failure to exchange Questionnaires that do not fall within the acceptable combination of elections will result in a lack of effective agreement between the parties, unless and until they arrive at Matched Questionnaires. In order to facilitate condition precedent matching, IDSA Amend will have the functionality to permit parties to submit "draft" Questionnaires, which may be amended before submission as "final."
The parties must match with respect to choice of Method of amendment of existing collateral documentation. A party may elect one or more of the New CSA Method, the Amend Method, and the Replicate-and-Amend Method, and separately whether or not it elects to enter into a new Protocol Master Agreement.
- The New CSA Method means to amend the ISDA Master Agreement to add a new 2016 VM CSA for post-Effective Date swaps (with pre-Effective Date swaps remaining collateralized under the existing collateral support document). A financial end user will elect this option if it prefers amendments to be applicable only to post-Effective Date swaps and elects that the new collateral support document will be on the basis of the terms of the 2016 VM CSA.
- The Replicate-and-Amend Method means to amend the ISDA Master Agreement by creating a replica of the existing CSA and then amending it to comply with the applicable Covered Margin Regime(s) (with pre-Effective Date swaps remaining collateralized under the existing CSA). This is a variant of the immediately preceding option, but it causes elections made in the existing collateral support document to be preserved in the new collateral support document to the extent possible.
- The Amend Method means to amend the existing CSA to make it comply with the applicable Covered Margin Regime(s) (the amended CSA will cover pre- and post-Effective Date swaps). A financial end user will elect this method if it wants to enter into new swaps under the ISDA Master Agreement with pre-and post-Effective Date swaps constituting the same netting portfolio.
- A Protocol Master Agreement means to enter into a new 2002 ISDA Master Agreement with a 2016 VM CSA for post-Effective Date CSAs, and with the terms of the new Master Agreement determined by the 2016 VM Protocol. This is a variant of the first point above, wherein instead of adding a second CSA to an existing ISDA Master Agreement, the parties elect to enter into both a new 2002 ISDA Master Agreement and a new 2016 VM CSA.
Each party not electing a Protocol Master Agreement is entitled to elect all or any of the Methods described above as a Method of entering into a regulation compliant collateral support document. The parties must agree on at least one Method. If they agree on more than one, the hierarchy is as follows: Amend Method, Replicate-and-Amend Method, New CSA. If the Questionnaires are not so matched, no agreement will be formed. If one party elects a new Protocol Master Agreement and the other does not, the elections will not match.
B. Selection of the Covered Margin Regimes
The VM Protocol is designed to address all applicable Covered Margin Regimes. The Questionnaire requires each party to select the Covered Margin Regimes applicable to it when trading with a particular counterparty. The party delivering the Questionnaire is not to take into account its understanding of the Covered Margin Regimes applicable to its counterparty. Since the U.S. margin rules only apply directly to Covered Entities, when responding to this question with respect to the U.S. margin rules, a financial end user should specify "None of the Above."8 The Covered Margin Regime(s) applicable to a pair of Matched Parties is the aggregate of the Covered Margin Regime(s) selected by either party.
C. Terms of a CSA
The following will be the principal terms of a collateral support document under the Amend, Replicate-and-Amend and New CSA Methods. This guide only discusses amendments effected by the provisions related to the U.S. margin regime, and in each case, assumes that the parties have elected NY CSA.
1. Terms of a CSA under the Amend Method and Replicate-and-Amend Method
If parties elect the Amend Method or the Replicate-and-Amend Method, their elections will be limited, and the remaining terms of their amended or new CSA will be as established by the terms of the Amend Method for CSA form or Replicate-and-Amend Method for CSA form. The Questionnaire provides for default provisions that the parties may override if they both decide on the same alternative.
Because the elections are few, and because the forms provide extensive optionality, e.g., between the Amend Method and the Replicate-and-Amend Method, as well as various Covered Margin Regimes, it may be difficult for financial end users to understand the terms of the resultant collateral support document. IHS Markit represents that ISDA Amend will have the functionality to provide counterparties with a print out of the collateral support document resulting from their elections, the applicable Covered Margin Regime(s) and the elected Method.
The elections available under the Questionnaire are as follows:
a. The Notification Time is the earlier of: (i) the time previously agreed by the parties, or (ii) 10:00 am in the same time zone as previously agreed by the parties; provided, that, if both parties elect the same alternative notification time specified in the Questionnaire, that election will control.
b. The Independent Amount will be as previously agreed by the parties, unless both parties elect to set the Independent Amount to zero.
c. For the Amend Method only, the effective date of the Amended CSA will be the earliest effective date of any relevant margin regime, unless both parties elect that the effective date will be five business days after delivery of Matched Questionnaires.
d. Covered Transactions under a Replicate-and-Amend or New CSA are limited to Transactions subject to any applicable Covered Margin Regime, unless both parties select Broad Product Set. If both parties elect Broad Product Set, the CSA will include all Transactions entered into after the earliest relevant variation margin compliance date.
In addition, the parties' existing CSA will be amended or replicated-and-amended as follows:
a. amend the definition of Eligible Collateral to be consistent with the U.S. margin rules, including specification of valuation percentages and FX haircuts
b. amend transfer timing to be compliant with the U.S. margin rules
c. amend the Minimum Transfer Amount to be the lesser of $400,000, and the amount otherwise agreed by the parties
d. amend Section 11 to give the Secured Party the right to send the Pledgor notice that it has determined that one or more items of eligible credit support no longer satisfies, or will no longer satisfy, eligibility requirements under applicable law and thereafter will have a value of zero
e. if the Method is Replicate-and-Amend, add provisions to establish the separate netting sets under the ISDA Master Agreement and provide for set off provisions as discussed in footnote 6
2. Terms of a CSA under the New CSA Method
New CSAs are based on the 2016 VM CSA discussed in IV.c.1 above. The terms of new CSAs are largely determined by default elections set forth in the Questionnaire, which the parties can override only if they both agree on the same specified alternative. Other terms can be added if both parties agree on the same specified additions. The following are the principal elections for new CSAs:
a. The Base Currency of the new CSA is by default the current Termination Currency of the ISDA Master Agreement (if the Termination Currency for both parties is the same "major currency and is non-discretionary), or otherwise is USD for a NY CSA, unless both parties elect the same alternative base currency.
b. Parties may specify Eligible Currencies in addition to the Base Currency as Eligible Collateral (VM). Such election will be effective to the extent both parties elect the same additional currencies specified in the Questionnaire. In addition, such election will be effective only if the Collateral Expansion Condition is satisfied. The Collateral Expansion Condition is satisfied if both parties agree that their consent is required to the substitution of collateral, or if both parties agree that their consent is not required for substitution of collateral.
c. Parties may elect to add Eligible Sovereign Debt as Eligible Collateral (VM). Such election will be effective to the extent both parties elect the same sovereign debt specified in the Questionnaire, and, as above, the Collateral Expansion Condition is satisfied.
d. The default Minimum Transfer Amount is $250,000, unless both parties select the same choice from the following: $0, $50,000, $100,000 or $400,000. Where one party has selected one of the alternative Minimum Transfer Amounts and the other party has not selected the same alternative Minimum Transfer Amount, the parties' Questionnaires will not be matched.
e. If parties have elected Broad Product Set, they may also elect (only if both parties make the election) to include all Transactions under the ISDA Master Agreement, and not just those after the relevant compliance date. In that case, the New CSA would cover both pre- and post-Effective Date Transactions.
f. The default election is that the Valuation Agent will be (i) the party making the demand for the purpose of collateral to be delivered or returned or dispute resolution, and (ii) the Secured Party for the purpose of delivery of distributions or interest amounts. However, the parties can agree that one party is to be the Valuation Agent for all purposes.
g. Interest Transfer is the default choice, and Interest Adjustment is not, unless both parties elect Interest Adjustment.
h. If the parties have previously agreed to apply negative interest in a Covered Protocol Agreement, that election will control. Otherwise, the default election is that negative interest will not apply unless both parties elect negative interest.
i. The default election is that daily interest compounding will not apply unless both parties elect that it will apply.
j. Paragraph 4(a) (Conditions Precedent) of the 2016 VM CSA will apply by default unless both parties elect otherwise.
VI. The Bottom Line
All financial end users will have to examine their collateral support documentation before March 1, 2017 to determine if amendment or new documentation is required. Once that determination is made, financial end users will have to determine how to go about the process of becoming regulation compliant: by means of a bilateral process or the industry-wide protocol. The more a financial end user is prepared with knowledge of the regulatory changes and the new ISDA documentation, the more agency it can exert over the outcome of its collateral support documentation.
1 The prudential regulators (the Comptroller of the Currency, the Board of Governors of the Federal Reserve, the Federal Deposit Insurance Corporation, the Farm Credit Administration and the Federal Housing Agency) are charged with adopting margin rules for federally insured deposit institutions, bank holding companies, foreign banks treated as bank holding companies, bank subsidiaries of bank holding companies and such foreign banks, farm credit banks, federal home loan banks, the Federal Home Loan Mortgage Corporation and the Federal National Mortgage Corporation.
2 Financial end users generally include bank holding companies and affiliates thereof, depository institutions, finance companies, licensed lenders, money services businesses, broker dealers, investment advisors, registered investment companies, commodity pools, certain private funds, insurance companies, employee benefit plans and pooled investment vehicles. Consistent with TRIPRA, Pub. L. 114-1, 129 Stat. 3 (2015), certain financial end users are exempt from the U.S. margin rules.
3 On September 1, 2016, Covered Entities were required to exchange initial and variation margin with counterparties if both the Covered Entity together with its margin affiliates and the counterparty and its margin affiliates had average daily aggregate notional amount of uncleared swaps exceeding $3 trillion.
4 Under the U.S. Margin rules, only financial end users with material swaps exposure ($8 billion notional amount of uncleared swaps, uncleared security-based swaps, FX swaps and FX forwards with all counterparties) are regulatorily required to post initial margin. The initial margin requirements under the U.S. margin rules are beyond the scope of this guide. This guide will discuss decisions to be made by financial end users in light of counterparty Covered Entities being subject to non-U.S. margin rules, but non-U.S. margin rules per se are beyond the scope of this guide.
5 ISDA has also published a 2016 Credit Support Annex for Variation Margin (VM) English Law and a 2016 Credit Support Annex for Variation Margin (VM) Japanese Law.
6 The prudential regulator margin rule contains certain provisions to accommodate different time zones and different local business days. Although the prudential regulator margin rule notes the validity of commentators' objections that transfer timing is not long enough to accommodate delivery and settlement timing, it states that counterparties may be required to take steps such as pre-positioning collateral and using readily transferrable forms of collateral such as cash, which can subsequently be substituted out with other eligible collateral.
7 If parties enter into a second collateral support document under an ISDA Master Agreement, in the event of the exercise of remedies with respect to posted collateral (VM), the parties will exercise their remedies separately with respect to posted collateral (VM) under the two collateral documents and the related netting portfolios. However, the parties may exercise set off and netting rights with respect to:
" the right of a pledgor to set-off a return obligation under one collateral support document against VM held by the secured party (or VM required to be return by the secured party) in each case under the second collateral support document
" the proceeds of liquidation of VM under one collateral support document (after satisfaction of the obligations due to the secured party under that collateral support document) to the satisfaction of any return obligations of the pledgor under the second collateral support document
In addition, the parties may elect that their obligations to transfer delivery amounts and return amounts under the two collateral documents due on the same date may be netted.
8 As noted in III above, Covered Margin Regimes includes the margin rules adopted by EU, Japan and Canada. The appropriate response with respect to such Covered Margin Regimes is beyond the scope of this guide.
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.