On June 25, 2020, the Federal Reserve, Farm Credit Administration, Federal Deposit Insurance Corporation, Federal Housing Finance Agency and Office of the Comptroller of the Currency (the "Agencies") finalized amendments to their swap margin rules and also issued an interim final rule that will extend the date by which certain swap entities and counterparties must comply with initial margin requirements for uncleared swap trading.1 The purpose of the amendments is to strengthen risk management for banks and swap-trading entities, as well as to facilitate compliance with swap margin rules during the LIBOR transition and the COVID-19 pandemic.
The swap margin rules originate from the Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank"). The rules govern capital and margin requirements for uncleared swaps traded by swap dealers and certain others regulated by one of the Agencies (covered swap entities). The rules originally provided a compliance schedule of five phases for meeting initial margin standards for covered swap entities trading uncleared swaps with all financial end users that have material swaps exposures by no later than September 1, 2020.
In November 2019, the Agencies sought comments on a proposal to amend certain aspects of the Rule relating to inter-affiliate swaps, amendments to legacy swaps relating to the LIBOR transition, additional time for smaller counterparties and timing of documentation requirements.2 The finalized rule3 (the "Final Rule") largely adopts those proposed amendments.
Earlier this year, the CFTC responded to industry-wide concerns about compliance with the September 1, 2020, deadline (phase 5) under its own swap margin rules4 by adding a phase 6 to its initial margin rules for swap dealers for entities with an average daily aggregate notional amount (AANA) between $8 billion and $50 billion and delaying compliance until September 1, 2021, consistent with guidance adopted by BCBS/IOSCO.5 Subsequently, in the wake of the COVID-19 pandemic, the CFTC issued an interim final rule extending the phase 5 compliance deadline for swap dealers with $50 billion to $750 billion in AANA to September 1, 2021.6
The Agencies have also responded to and formally addressed these concerns in the Final Rule and an interim final rule, as discussed below, which together create a sixth phase of initial margin compliance for smaller entities that must be met by September 1, 2022, and extend the phase 5 implementation deadline to September 1, 2021.7
The Final Rule, the interim final rule and guidance regarding uncleared swap transactions between a bank and its affiliates are summarized below.
The Finalized Swap Margin Rule
The Final Rule (1) permits swaps entered into prior to an applicable compliance date (so-called "legacy swaps") to retain their legacy status if they are amended due to the cessation of LIBOR or another IBOR; (2) modifies initial margin requirements for uncleared swaps between covered swap entities and their affiliates; (3) introduces an additional "phase 6" compliance date for initial margin requirements; (4) clarifies the date on which trading documentation must be in place; (5) permits legacy swaps to retain their legacy status if they are amended because of technical amendments, notional reductions or portfolio compressions; and (6) makes technical changes to relocate the provision addressing amendments to legacy swaps that are made to comply with qualified financial contract (QFC) rules.
More specifically, under the Final Rule:
- Insured depository institutions will not be required to collect initial margin from an affiliate for uncleared swaps, unless the institution's aggregate inter-affiliate initial margin calculation amount exceeds 15% of its Tier 1 capital;
- Foreign firms, including foreign banks, their non-U.S. subsidiaries and their U.S. branches and agencies, will be entirely exempt from collecting initial margin from their affiliates;
- Banks will remain subject to variation margin requirements with respect to their trades with affiliates;
- Covered swap entities can amend legacy swaps to replace references to LIBOR and other IBORs without becoming subject to regulatory margin requirements;
- Covered swap entities may conduct portfolio compressions or make other non-substantive amendments for logistical or risk-management purposes or to reduce the notional amount to their legacy swap portfolios without losing their legacy status;
- Compliance with phase five (with an original compliance date of September 1, 2020, modified as described below) was changed to cover entities with $50 billion to $750 billion of AANA and a new compliance date for phase six of September 1, 2021, was added for covered swap entities and financial end-users with $8 billion to $50 billion of AANA;
- a covered swap entity will not be required to execute initial margin trading documentation prior to the time it is required to collect or post initial margin but instead must submit such documentation only after either (1) initial margin is required to be collected or posted or (2) when a covered swap entity posts initial margin above the required amount;
- the interim final rule which, in the event that the U.K. withdraws from the EU without a Withdrawal Agreement, enables financial entities in the U.K. to transfer existing uncleared swap portfolios to an affiliate in the U.S. or EU Member State without becoming subject to regulatory margin requirements,8 will be incorporated; and
- the Federal Reserve and other prudential regulators will continue to treat commercial and cooperative end user swaps as exempt if any LIBOR-related amendments are consistent with the terms of related CFTC no-action letters.
The Final Rule will become effective on August 31, 2020.
The Interim Final Rule
The interim final rule will extend the implementation deadlines for initial margin requirements for phase five to September 1, 2021, and for phase six to September 1, 2022.
A one-year extension for both phases will allow covered swap entities to respond to the impact of COVID-19 and allow covered swap entities to prioritize compliance with respect to transactions with certain larger counterparties.
The interim final rule will become effective on September 1, 2020. Comments are due on or before August 31, 2020.
Bank Affiliate Transaction Rules
Although the Final Rule generally provides that non-cleared swaps between a bank and its affiliates are not subject to the initial margin requirements of the swap margin rule (subject to certain conditions), derivatives transactions and many other types of transactions between a bank and its affiliates (covered transactions) are subject to quantitative and qualitative limits and restrictions under Sections 23A and 23B of the Federal Reserve Act and the Federal Reserve's Regulation W.9
Section 23A provides that a derivative transaction between a bank and its affiliate is a covered transaction to the extent that the bank incurs credit exposure to the affiliate. Neither Section 23A nor Regulation W defines "credit exposure." Section 23B generally requires a bank to engage in covered transactions with affiliates on arm's-length terms and conditions (i.e., on terms at least as favorable to the bank as those of the bank's comparable transactions with non-affiliates).
The Federal Reserve stated that bank-affiliate derivatives generally can be valued at the bank's current exposure to the affiliate. As a result, the Federal Reserve believes that a bank must collect 23A-compliant variation margin from its affiliates to cover its current exposure on derivative transactions with affiliates. However, the Federal Reserve stated that Section 23A generally does not require a bank to collect initial margin to cover the bank's potential future exposure on the transactions.
With respect to the market terms requirement of Section 23B, the Federal Reserve noted that banks typically collect initial margin from third parties. This fact raises the possibility that a bank would need to collect initial margin from an affiliate in order to comply with Section 23B. However, the Federal Reserve observed that in many cases it would be reasonable to conclude that a swap with no initial margin requirement is at least as favorable to the bank as a comparable bank-non-affiliate swap with two-way initial margin requirements when the bank and affiliate each agree not to require an equivalent exchange of initial margin from the other.
The Federal Reserve further cautioned that, in specific cases, bank-affiliate swap arrangements without initial margin requirements could nevertheless raise issues under Section 23B. Relevant factors to consider would be the relative creditworthiness of the bank compared to the affiliate, whether the bank-affiliate swap portfolio is more likely to create potential future exposure of the bank to the affiliate or vice versa and whether or not the affiliate requires initial margin from the bank under the swap arrangement.
The Agencies' changes and extensions should allow market participants to comply with margin regulations while also managing the challenges posed by the LIBOR transition and COVID-19. The Federal Reserve's statement provides greater clarity regarding the application of Sections 23A and 23B to margin requirements for bank-affiliate transactions.
1. Agencies Finalize Amendments to Swap Margin Rule (June 25, 2020).
2. Margin and Capital Requirements for Covered Swap Entities, 84 FR 59970 (November 7, 2019).
3. See Margin and Capital Requirements for Covered Swap Entities, 85 FR 39754 (July 1, 2020).
4. See Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 81 FR 636 (January 6, 2016).
5. See Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 85 FR 19878 (May 11, 2020).
6. CFTC Unanimously Approves an Interim Final Rule and a Proposed Rule at May 28 Open Meeting (May 28, 2020). The CFTC has also indicated that it intends to propose moving the phase 6 implementation deadline to September 2022.
7. Margin and Capital Requirements for Covered Swap Entities, 85 FR 39464 (July 1, 2020).
8. Margin and Capital Requirements for Covered Swap Entities, 84 FR 9940 (March 19, 2019). A Withdrawal Agreement between the U.K. and EU was ratified in January 2020 and incorporates a transition period that runs until December 31, 2020, and could be extended by one or two years.
9. Federal Reserve Act, section 23A; Federal Reserve Act, section 23B; Transactions Between Member Banks and Their Affiliates (Regulation W), 12 CFR 223 (January 1, 2011).
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