CFTC Plants Seed For Targeted Fund Relief And Grows Eligible Collateral Base In Proposed Changes To The Uncleared Swap Margin Requirements - Financial Services

On July 26, 2023, the CFTC proposed rule amendments to the non-bank swap dealer uncleared margin requirements (UMR) in an open meeting.¹ If adopted, the notice of proposed rulemaking (NPRM) would amend non-bank swap dealer UMR by adopting two separate advisory committee recommendations made by the Global Market Advisory Committee (GMAC) in 2020. This illustrates the importance of the Commission's advisory committees and members, as the NPRM would adopt revisions to the UMR largely as recommended by the GMAC.

The NPRM (1) excludes certain sponsored collective investment vehicles (Seeded Funds) and their non-bank swap dealer counterparties from the requirement to exchange initial margin (IM) (Seeded Fund Proposal); and (2) permits non-bank SDs and their counterparties to use additional money market funds (MMFs) as eligible collateral in satisfaction of IM requirements by removing asset transfer restrictions that prohibit MMFs from being used in securities financing transaction-related (SFT) arrangements² (MMF Collateral Proposal). If adopted, the UMR revisions would allow Seeded Funds to direct more of their start-up capital to investment or business initiatives, and afford non-bank SDs, their counterparties and custodians added flexibility in their MMF selection processes while potentially generating higher returns on IM collateral by allowing the posting of MMFs that use SFTs.³

While we anticipate the revisions should be favorable to swap market participants by excluding additional counterparties from the CFTC UMR and loosening collateral restrictions, swap dealers, asset managers, MMFs, investment funds, and custodians should strongly consider commenting on the proposal, particularly in light of opposition by one Democratic CFTC Commissioner.⁴ Although one dissenting vote will not prevent the NPRM's adoption, opposition within the "majority party" of the Commission could suggest further substantive changes may be forthcoming in the final rule's adopting release.

Comments must be submitted no later than October 10, 2023.

Takeaways from the Seeded Fund Proposal (if adopted)

Seeded Funds (and their SD counterparties) would not be required to affirmatively notify the CFTC if electing to take the eligible seeded fund exception, which differs from other UMR exceptions that require such notice (e.g., the hedging end-user exception).
Seeded Funds and their non-bank swap dealer affiliates would need to consider revising credit support documentation to reflect changes to the IM Threshold Amount. For example:
- A Seeded Fund individually satisfying the Material Swaps Exposure (MSE) threshold should consider negotiating amended CSAs with non-bank swap dealer counterparties to reflect a $50M IM Threshold Amount.
- Current margin affiliates of Seeded Funds would need to consider revising CSA's with shared counterparties to increase their IM Threshold Amount allocation and acknowledge Seeded Fund trading exposures.
Sponsors pay the (IM) tab. A sponsor would consolidate the Seeded Fund's swap exposures with its own (and those of any margin affiliates) across shared counterparties, likely increasing the sponsor's IM cost.
A Seeded Fund should consider whether it has an obligation or duty to notify a non-bank swap dealer counterparty of any corrections to representations made based on trade aggregation with margin affiliates.
Unless the Prudential Regulators (PR) pursue similar revisions to the UMR framework applicable to bank swap dealers, Seeded Funds will be financially incentivized to transfer existing netting portfolios to, and execute new trades with, non-bank swap dealers to reduce (or eliminate) IM costs.

Overview of Seeded Fund Proposal

Seeded Funds, which receive start-up capital from sponsors such as swap dealers, insurance companies and other entities, would be eligible for the exclusion for a period of three years beginning after the fund's initial investment.
Seeded Funds are generally treated as margin affiliates of their sponsors, sometimes subjecting them to IM requirements due to swap aggregation requirements across corporate families (and not their individual trading activities).
Seeded Funds satisfying certain conditions (Eligible Seeded Fund) would be permitted to exclude their swaps from MSE and IM Threshold Amount calculations with margin affiliates.
Among other conditions, the Seeded Fund must be a distinct legal entity from each sponsor; one of the fund's margin affiliates must be required to post and collect initial margin; and the fund's investment strategy must follow a written plan to divest over a three-year period. The exclusion would not apply to securitization vehicles.⁵
Eligible Seeded Funds would be excluded from IM requirements but otherwise remain subject to variation margin requirements.
The exclusion is only available to Eligible Seeded Funds and not their sponsors and margin affiliates. As a result, Seeded Fund-generated swap exposures would be included in the MSE and IM Threshold Amount calculations of sponsors and margin affiliates.

Takeaways from the MMF Proposal (if adopted)

Permitting the rehypothecation of IM collateral under the limited circumstances of the rule would align the non-bank approach with the BCBS/IOSCO and international standards adopted by Australia, Canada, the European Union, and Japan, but conflict with what would become a more restrictive PR IM collateral reuse standard.
The asset transfer adjustment could enable more banking custodians to provide IM segregation services, although a similar loosening of such standards by the PR may be needed to facilitate more custodian entrants into the IM segregation market.
Covered counterparties (and their custodians) should review investment management and related agreements that govern the investment activities and composition of MMFs to identify newly compliant funds.
Firms should consider submitting comment letters and pursuing advocacy efforts, particularly on issues where the Commission seeks comment. For example, the Commission could consider removing the current asset transfer restriction only for cleared SFTs.⁶
Firms will likely need to amend existing IM credit support documentation to acknowledge the weighted average haircut to be applied to eligible investment funds. The haircut was inadvertently omitted from the UMR adopting release.

Overview of the MMF Proposal

Redeemable securities, or MMFs, transferred through SFT arrangements, constitute an impermissible use of IM collateral under current CFTC and PR UMR.
The restriction exists despite shares in a particular MMF otherwise satisfying eligible forms of IM collateral (e.g., treasuries, G-20 debt securities, and other forms of high-quality liquid assets) under both CFTC and PR UMR rulesets.
According to the GMAC Report submitted to the CFTC, only four (4) MMFs are able to satisfy existing requirements as a result of the asset transfer restriction.
The asset transfer restriction was adopted "to ensure consistency with the prohibition under the final rule against custodian rehypothecation of initial margin collateral"⁷and to eliminate or mitigate a posting party's counterparty credit risk to third-parties.
The CFTC believes permitting MMFs to engage in SFT-related transactions is appropriate given that a default impacting an SFT-transaction would be mitigated by the assets held by the non-defaulting party under the SFT exchange.
Adjustments to rehypothecation requirements are not new to the UMR rulemaking process. Previously:
- rehypothecation prohibitions in the PR and CFTC UMR proposals may have precluded in-scope entities (and their custodians) from converting cash into money market or sweep funds altogether, prompting the finalized UMR to acknowledge long-standing custodian operational "sweep" processes and permitting firms to convert cash deposits into pooled investment vehicles; ⁸ and
- MMFs and redeemable securities were added to the list of eligible collateral on the condition that the underlying investments of the fund themselves must only be comprised of eligible collateral.
To align with the current PR Rule, the CFTC would revise its standardized IM haircut schedule to add a haircut / discount for pooled investment funds based on the weighted average discount on the assets comprising the fund.

Footnotes

1. Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 88 Fed. Reg. 53,409 (proposed Aug 8, 2023).

2. Pursuant to CFTC Rule 23.156(a)(1)(ix)(C), the assets of the MMF may not be transferred through securities lending or borrowing, repurchase agreements, reverse repurchase agreements, or "or other means that involve the fund having rights to acquire the same or similar assets from the transferee."

3. The GMAC Report notes that MMFs use SFTs to "earn returns on cash and other high quality assets, avoid any cash drag on performance, diversify its investments" while mitigating potential exposure in the event of a custodian insolvency and to avoid any consolidation issues with cash.

4. See Dissenting Statement of Commissioner Christy Goldsmith Romero on Notice of Proposed Rule Making for Seeded Funds and Money Market Funds (July 26, 2023). Available at: https://www.cftc.gov/PressRoom/SpeechesTestimony/romerostatement072623e.

5. For an exhaustive listing of conditions that must be satisfied by a Seeded Fund seeking to exclude itself from the IM requirements, see Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 88 Fed. Reg. 53,409, at 53,427 (Aug 8, 2023) (proposed to be codified at 17 C.F.R. § 23.151 (Eligible seeded fund)).

6. For example, one request for comment (#11) of the NPRM asks, in relevant part, whether the Commission should allow "the securities of money market and similar funds to qualify as eligible collateral only if a fund's repurchase or similar arrangements are cleared? Should the Commission impose any additional limits or conditions, such as restrictions on the type and terms of the repurchase or similar arrangements permitted for money market and similar funds for their shares to qualify as eligible collateral?"

7. Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 81 Fed. Reg. 636, at 666 (Jan 2, 2016).

8. See CFTC Rule 23.157(c)(1) and 12 C.F.R. 217.37(c)(1), prohibiting the rehypothecation of segregated initial margin, "except that cash collateral may be held in a general deposit account with the custodian if the funds in the account are used to purchase [IM eligible collateral]," held in a compliant account and manner, and the purchase takes place within an appropriate time period after the cash collateral is posted.

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