United States: CFTC Chair Christopher Giancarlo Wants Clarifications On Initial Margin "Phase Five" Implementation

Last Updated: May 20 2019
Article by Nihal S. Patel and Steven D. Lofchie

CFTC Chair J. Christopher Giancarlo urged U.S. regulators to clarify obligations for dealers to exchange initial margin ("IM") where requirements are below the $50 million threshold amount specified in the rules.

In a letter to Federal Reserve Board Vice Chair Randal K. Quarles, Mr. Giancarlo transmitted the concerns voiced by many small-market participants that will be affected by "Phase Five" of the implementation of swaps initial margin requirements in 2020. Mr. Giancarlo stated that smaller entities may be required to incur time and expense in making operations and documentation preparations, even where they may not be required to exchange margin due to the $50 million threshold specified in the rules or because their trading activities (e.g., for foreign exchange ("FX") swaps and FX forwards) are not in scope for any margin requirement.

Citing CFTC staff analysis, Mr. Giancarlo recommended that:

  • U.S. regulators clarify through regulatory guidance that dealers need not have systems and documentation in place for the exchange of IM where the calculated IM for a relevant counterparty is below the $50 million threshold; and
  • global regulators work with BCBS/IOSCO to ensure that global principles do not impose requirements when the IM amount is below the EUR 50 million threshold.

Mr. Giancarlo said that CFTC data analysis found that increasing the $8 billion measuring trigger before IM rules apply (part of the definition of "material swaps exposure") could "raise concerns about risks to the financial system not intended by the current regulatory structure," and that some firms might drop out of scope in such a change even though their calculated IM requirement would exceed $50 million.

Mr. Giancarlo sent a copy of the letter to regulators at the Bank of England, the UK Financial Conduct Authority and the European Securities and Markets Authority.

Commentary / Nihal Patel

Mr. Giancarlo's letter is, essentially, an argument that U.S. regulators should implement one of the recommendations made in a BCBS/IOSCO statement in March 2019. It also seems to be an indication that the CFTC does not intend to take unilateral action to make changes to its rules (or issue "guidance") without the banking regulators taking equivalent steps for their rules.

This approach is completely reasonable. Indeed, the need for relief may be an unintended drafting point based on the adopted U.S. swaps margin rules rather than an explicit regulatory policy. In other jurisdictions with substantially similar derivatives margin rules as the United States, additional changes may not even be necessary, as those rules may already not explicitly require documentation and other steps to be taken where no actual margin is required to be exchanged.

Perhaps the most notable aspect of Mr. Giancarlo's letter is his statement not supporting an increase in the measuring trigger from $8 billion, as urged by a large collective of financial industry trade groups. Mr. Giancarlo states that such an increase could raise systemic risk concerns. This may be true (it is almost certainly the case that entities that trade more tend to have more risk on their books), but it also highlights one of the problems with the rules as written: notional trading amounts are not good risk measurements. Mr. Giancarlo acknowledges this point when noting that an entity with $8 billion in notional activity could merit a large or small margin requirement depending on the risk associated with its trading, but not when suggesting that an increase from $8 billion raises systemic risk concerns.

In Mr. Giancarlo's defense, basing margin requirements solely on risk raises questions of its own. If regulators were to require dealers to exchange IM with any counterparty (regardless of notional activity) where the IM requirement exceeds $50 million, it would present significant operational and tracking burdens on dealers, as their counterparties would likely be unable to represent to them in advance as to whether they would exceed this amount and dealers would no longer be able to rule out all counterparties with less than $8 billion in notional activity.*

In the absence of a consensus as to a better way to deal with this problem, Mr. Giancarlo seems to make the case that notional amounts continue to make sense as a somewhat arbitrary "filter," with risk (i.e., determining if the actual requirement is over $50 million) being a second-level determinant. As to what amount makes sense for this somewhat arbitrary trigger, Mr. Giancarlo makes a (rather brief) argument that eight is enough.

*On a separate note, this administrative burden should be less of a barrier for moving away from the use of notional amounts for purposes of determining whether registration is required as a "swap dealer." In that context, only one entity is performing the tracking function, whereas derivatives margin puts the burden on a dealer to identify the amount across all of its counterparties. Hopefully, the CFTC will revisit the de minimis counting question soon, something for which Commissioner Quintenz has made a strong push.

Commentary / Steven Lofchie

Dodd-Frank significantly increased the authority of, and the responsibilities imposed on, the banking regulators, particularly the Federal Reserve Board. Given these greater responsibilities, it is not surprising that bank regulators wish to be cautious. On the other hand, it is their duty to become more familiar with the products and markets that their authority now impacts. To the extent that the regulators exercise undue caution because of a lack of familiarity with a market or product, that undue caution is directly detrimental to the markets. In this regard, it certainly seems as if the measure of controls that the bank regulators impose as to swaps or as to securities financing transactions is completely disproportionate with controls as to traditional banking products that are arguably substantially riskier. See also CFTC Commissioners Criticize the Supplemental Leverage Ratio.

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.

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