Eileen Bannon is a Partner for Holland and Knight's New York office.
Thomas Morante is a Partner for Holland & Knights Ft Lauderdale office.
- March 1, 2017, is the scheduled implementation date applicable for all insurance companies for the mandatory posting of variation margin to their swap dealer counterparties under U.S. margin rules.
- In most cases, insurance companies will be required to amend existing documentation or enter into new documentation for posting of collateral for their derivatives transactions.
- Although the obligation to enter into regulation compliant documentation falls on swap dealers, an insurance company will not be permitted to trade under its existing derivatives documentation on and after March 1, 2017, until its documentation complies with the new U.S. margin regulations.
March 1, 2017, is the scheduled implementation date applicable for all insurance companies for the mandatory posting of variation margin to their swap dealer counterparties under U.S. margin rules.
Although the obligation to enter into regulation compliant documentation falls on swap dealers, an insurance company will not be permitted to trade under its existing derivatives documentation on and after the implementation date until its documentation complies with the new margin regulations.
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 swaps1 entered into with "financial end users," as defined in the U,S. margin rules. Financial end users include all entities organized as insurance companies, primarily engaged in writing insurance or reinsuring risks written by insurance companies, or subject to supervision by a state insurance regulator or a foreign insurance regulator. Variation margin is the mark-to-market change in the value of the swap. The scheduled implementation date of the U.S. margin rules for variation margin rules is March 1, 2017 (the Effective Date).
Margin regulations have also been adopted for the European Union (EU), Canada, Japan and Australia (together with the U.S., Covered Margin Regimes) with a general market variation margin compliance date of March 1, 2017. An insurance company may be required to enter into documentation that is compliant with the U.S. margin rules because its counterparty is registered as a U.S. swap dealer and/or documentation that is also compliant with another Covered Margin Regime because its counterparty is subject to the jurisdiction of that other regime.2
The U.S. margin rules require Covered Entities to execute documentation with counterparties providing for the exchange of initial3 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 alert addresses the options potentially available to insurance companies 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
The 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 (2016 VM CSA). In addition, in order to accommodate the "big bang" simultaneous implementation of the variation margin rules of the different Covered Margin Regimes on March 1, 2017, ISDA has also 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 Covered Margin 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 has also published a Regulatory Margin Self Disclosure Letter designed to inform Covered Entities under the various Covered Margin Regimes of characteristics of their counterparties so that the Covered Entities can determine the applicable 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.
Insurance Company 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 an insurance company 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 an insurance company 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.
- 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.5
- 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, 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, an insurance company 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 insurance company will also need to decide whether or not to:
- 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), or
- 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 an insurance company 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 an insurance company 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 that is compliant with the U.S. margin rules?
1. Bespoke Documentation or 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. The 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, the 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 an insurance company, it may be difficult for the related Covered Entity to accomplish before the Effective Date.
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 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 an insurance company has a swap relationship with a Covered Entity subject to multiple Covered Margin Regimes, an insurance company may determine that the VM Protocol is the preferable alternative for that swap relationship. It is also likely that certain Covered Entities will expect insurance companies to enter into compliant documentation by means of the VM Protocol.
Caveats to the advantages of the VM Protocol are that it is complicated and it may be difficult for insurance companies to understand its architecture and elections. Moreover, elections are limited and the non-elective terms of the amended or new collateral support document will be as established by the terms of the VM Protocol. The protocol provides for default provisions which the parties may only override if they both decide on the same alternative.
Finally, after going through the VM Protocol process and matching differently with different swap dealer counterparties, it may be difficult for insurance companies to understand the terms of the resultant collateral support document with each counterparty. Markit represents that ISDA Amend will have the functionality to provide counterparties with a printout of the collateral support document resulting from their elections and the applicable Covered Margin Regime(s), but such printout may not resemble a standard collateral support document.
The Bottom Line
All insurance companies 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, insurance companies will have to determine how to go about that process: by means of a bilateral process or the industry-wide protocol. An insurance company may decide to take one approach for certain swap relationships and the other approach for the remainder. The more an insurance company is prepared with knowledge of the regulatory changes and the new ISDA documentation, the easier it will be for the insurance company to achieve regulation compliant documentation by the Effective Date.
1. Security-based swaps are subject to the U.S. margin rules if the related swap dealer is subject to supervisory authority by a prudential regulator (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).
2. On Feb. 1, 2017, the Commodity Futures Trading Commission issued a no-action letter providing that swap dealers subject to its jurisdiction (i.e., not subject to supervisory authority by a prudential regulator) are not required to comply with U.S. margin rules until May 8, 2017, so long as they are in compliance with the EU margin rules.
3. Initial margin is collateral posted in addition to variation margin designed to protect the counterparty against changes in the mark-to-market value of the derivative upon termination and replacement.
4. Under the U.S. margin rules, only insurance companies with material swaps exposure ($8 billion notional amount of uncleared swaps, uncleared security-based swaps, foreign exchange (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 alert.
5. If the Covered Entity is subject to regulation by a prudential regulator, the applicable U.S. margin rule contains certain provisions to accommodate different time zones. Although such U.S. margin rule notes the validity of the 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 that can subsequently be substituted out with other eligible collateral.
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.