United States: CFTC Division Of Clearing And Risk Determines Variation Margin Payments Are Settlements

The CFTC Division of Clearing and Risk ("DCR") issued an Interpretive Letter clarifying that variation margin ("VM") for cleared swap positions constitutes the daily settlement of exposure and not collateral under the Commodity Exchange Act ("CEA").

In the letter, the DCR explained that VM for cleared swaps may be transferred under either of two separate legal models: a "collateralized-to-market model" or a "settled-to-market model." Different jurisdictions may permit or require either model, though both achieve the same risk mitigation results. Under the collateralized-to-market model, VM is characterized as collateral, exposures are deemed to carry forward, and the party receiving VM commonly pays interest (often called price alignment interest, or "PAI") on cash collateral received. Under the settled-to-market model, VM payments are characterized as fully settling the outstanding exposure of the counterparties and, regardless of how exposure changes over the following day, neither counterparty is required to return a VM payment. Nevertheless, payments equivalent to PAI (which the CFTC calls price alignment amounts, or "PAA") generally are required of the party receiving VM.

The DCR noted that under CEA Section 5b(c)(2)(E) and CFTC Regulation 39.14, a derivatives clearing organization ("DCO") must effect a final settlement at least once each business day, including for VM. Under CFTC Regulation 22.3, "cleared swap customer collateral" must be segregated by a DCO. According to the DCR, the rulemaking records support the conclusion that the U.S. requires the settled-to-market model. In particular, the DCR highlighted CFTC statements that VM payments do not involve the carrying forward of daily exposures, and that VM may be transferred by DCOs to parties that are "in-the-money" rather than segregated. The DCR also notes that the CFTC has adopted a broad definition of "settlement," which includes "all cash flows between a clearing member and a DCO."

In accordance with these findings, the DCR concluded that VM is characterized as settlement under the CEA. The DCR also advised that a collateralized-to-market system "would not satisfy Commission regulations," and that rules for each DCO "must reflect that VM payments constitute settlement of outstanding exposures."

Commentary / Jeff Robins

The DCR's Interpretive Letter seems to complete the quest for recognition of cleared swap VM as settlement for purposes of regulatory capital. Market participants and DCOs have, for several years, been engaged in a process of re-interpreting, clarifying and, where necessary, amending DCO rules to try to establish this recognition, notwithstanding that VM continues to generate requirements for the receiving party to pay "PAI" or "PAA." A recent statement by the banking regulators provided space to recognize VM as settlement, but warned that market participants were required to evaluate whether the relevant VM payments accomplished full transfer of all legal claims and constituted settlement under applicable agreements, rules, and law. The DCR interpretation is clearly intended to help establish these conditions.

While that outcome is clearly good news for banks, one oddity of the DCR's interpretation is its apparent insistence that transferring VM as collateral is inconsistent with CFTC regulations. While a collateralized-to-market approach is in some tension with the CEA, the CFTC and the market have lived with that tension without any real harm. One would think the DCR could have stopped after stating that settlement to market is consistent with law and that CFTC rules treat either approach as "settlement." By going further, the DCR may have unnecessarily reduced choice and made it difficult for intermediaries subject to legal regimes requiring collateralization to participate in the U.S. market.

The DCR's reasons for taking that additional step are not entirely clear. It may have felt compelled to do so in order to satisfy the banking regulators. However, that just highlights the arbitrary line drawing in the capital rules. Given that the two models really are equivalent from a risk and economic standpoint, the capital treatment should not depend on formalistic distinctions between them.

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