United States: Structured Thoughts: News for the Financial Services Community, Volume 10, Issue 4

THE SEC'S MARGIN REQUIREMENTS FOR SECURITY-BASED SWAP DEALERS

On June 21, 2019, the Securities and Exchange Commission ("SEC") released its final rules (the "Final Rules") stating margin requirements for security-based swap dealers (each, an "SBSD") and major security-based swap participants (each, an "MSBSP")1 in connection with security-based swaps ("SBS").2 The SEC's decision to release its margin rules in final form was contrary to the stated preference of a significant portion of the market, which took the view that, as more than six years had passed since the SEC had proposed the rules in 2012, and as other regulatory bodies since that time had either proposed or finalized margin requirements pursuant to their own mandates, the SEC should repropose the rules rather than issue them in final form. In any event, when implemented, the Final Rules, available here, will require SBSDs to collect margin from, and provide margin to, many SBS counterparties. We expect that these requirements will have a significant impact on the economics of the SBS market.

The release accompanying the Final Rules provides market participants with what appears to be an ample amount of time to comply with the rules' requirements. The release sets the date for compliance, both with the rules themselves and with the registration requirement for SBSDs, as 18 months after the later of (i) the effective date of final rules establishing recordkeeping and reporting requirements for SBSDs and MSBSPs or (ii) the effective date of final rules addressing the crossborder application of certain security-based swap requirements. The SEC has not finalized either of these rulesets. While the SEC proposed recordkeeping and reporting rules for SBSDs and MSBSPs some time ago, in 2014, it proposed cross-border rules recently, in May 2019. As a result, the compliance date for the Final Rules will be more, and perhaps significantly more, than 18 months from now.

The Final Rules, which apply to SBSDs not subject to prudential banking regulation ("nonbanks") with respect to non-cleared SBS, resemble both the margin rules of the CFTC (the "CFTC Rules"), which apply to nonbank swap dealers with respect to non-cleared swaps, and the margin rules of the prudential banking regulators (the "PR Rules"), which apply to prudentially regulated banks that are swap dealers or SBSDs with respect to both non-cleared swaps and non-cleared SBS. However, there is only a general resemblance between the Final Rules, on the one hand, and the CFTC Rules and the PR Rules (which in many respects are virtually identical to each other), on the other; the Final Rules follow the SEC's pattern of conforming its rules for SBS to the CFTC's rules for swaps, but not conforming them completely. Given the similarities between the SEC's mandate to regulate SBS and the CFTC's mandate to regulate swaps, and the logistical challenges of complying with similar but different rules for similar but different types of transactions, market participants could be forgiven for wishing a tighter congruence between the Final Rules and the CFTC Rules.

The Final Rules, which apply to SBSDs not subject to prudential banking regulation ("nonbanks") with respect to non-cleared SBS, resemble both the margin rules of the CFTC (the "CFTC Rules"), which apply to nonbank swap dealers with respect to non-cleared swaps, and the margin rules of the prudential banking regulators (the "PR Rules"), which apply to prudentially regulated banks that are swap dealers or SBSDs with respect to both non-cleared swaps and non-cleared SBS. However, there is only a general resemblance between the Final Rules, on the one hand, and the CFTC Rules and the PR Rules (which in many respects are virtually identical to each other), on the other; the Final Rules follow the SEC's pattern of conforming its rules for SBS to the CFTC's rules for swaps, but not conforming them completely. Given the similarities between the SEC's mandate to regulate SBS and the CFTC's mandate to regulate swaps, and the logistical challenges of complying with similar but different rules for similar but different types of transactions, market participants could be forgiven for wishing a tighter congruence between the Final Rules and the CFTC Rules.

Despite the differences between the Final Rules and the CFTC Rules, however, the Final Rules permit SBSDs, under certain circumstances, to comply with the CFTC Rules rather than the Final Rules. Under an "alternative compliance mechanism" provided by the Final Rules, an SBSD that is registered with the CFTC as a swap dealer, if it meets certain conditions, may treat SBS and related collateral in accordance with the CFTC Rules, rather than the Final Rules, to the extent the CFTC Rules do not specifically address SBS and related collateral.

To avail itself of such alternative compliance mechanism, an SBSD must not be a registered broker or dealer. In addition, among other conditions, the SBSD must engage predominantly in swaps business rather than SBS business. The aggregate gross notional amount of the outstanding SBS positions of the SBSD must not exceed the lesser of (i) 10 percent of the combined aggregate gross notional amount of the SBS and swap positions of the SBSD and (ii) a maximum fixed-dollar amount specified in the Final Rules, which amount will be $250 billion until the three-year anniversary of the Final Rules' compliance date, at which time the maximum fixed-dollar amount will drop to $50 billion unless the SEC issues an order stating otherwise.

The Final Rules require an SBSD to calculate daily for its counterparties both (i) the amount of current exposure (corresponding to variation margin) and (ii) the required amount of initial margin (based in part on potential future exposure). Subject to the exceptions noted below, an SBSD must collect collateral from, or deliver collateral to, its SBS counterparties in relation to variation margin, and must collect collateral from its SBS counterparties in relation to initial margin requirements. Unlike the CFTC Rules and the PR Rules, the Final Rules do not require a dealer to post initial margin to any counterparty. An SBSD must deliver or collect required margin by no later than the close of business of the first business day following the day of the related calculation, unless the counterparty is located in another country and more than four time zones away, in which case the deadline is the second business day following the day of the required calculation.

The Final Rules exempt SBSDs from SBS margin requirements in relation to certain types of counterparties. SBSDs need not collect initial or variation margin, or provide variation margin to (i) SBS legacy accounts, which hold no SBS entered into after the Final Rules' compliance date, (ii) the Bank for International Settlements, the European Stability Mechanism and multilateral development banks or (iii) commercial end users, a term defined with reference to the statutory exception from mandatory clearing for counterparties that are not "financial entities."

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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.

© Morrison & Foerster LLP. All rights reserved

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