Final Rules on Segregation of Initial Margin for Uncleared Swaps Issued by CFTC

Practical Law Legal Update 3-548-2087 (Approx. 5 pages)

Final Rules on Segregation of Initial Margin for Uncleared Swaps Issued by CFTC

by Practical Law Finance

Published on 07 Nov 2013 • USA (National/Federal)

The CFTC released final rules on segregation requirements for initial margin posted in connection with uncleared swaps under Section 724(c) of the Dodd-Frank Act. The rules also increased protection of cleared swap portfolio margining arrangements.

On October 30, 2013, the CFTC adopted a final rule that requires swap dealers (SDs) and major swap participants (MSPs), upon request by a customer, to segregate initial margin posted by the customer to collateralize uncleared swaps between them. The rule requires that segregated margin be held by an independent third-party custodian. Under Section 724(c) of the Dodd-Frank Act, which added Section 4s(l) to the CEA, SDs and MSPs must notify their counterparty of this right, which was included by legislators in response to Lehman and other dealer failures in which commingled, rehypothecated customer collateral was difficult to identify, trace and recover. With independent third-party segregation, a counterparty's collateral is not a part of a defunct dealer's bankruptcy estate.

Note that Section 4s(l) of the CEA sets out the rights of non-SD/non-MSP swap counterparties to have their SD and MSP counterparties segregate with an independent third-party custodian any money, securities or other property it uses to margin, guarantee or otherwise secure uncleared swaps between them. CFTC Regulation 23.701 covers the obligations of SDs and MSPs with respect to counterparty notification of these segregation rights.

Swap counterparties have no similar right to segregation of variation margin.

As part of the same rulemaking, the CFTC also expanded the definition of "customer property" under CFTC Regulation Part 190 to provide cleared swap portfolio margining arrangements with the same protections in a commodity broker liquidation under subchapter IV of chapter 7 of the Bankruptcy Code as are already afforded futures portfolio margining arrangements.

The final rule on uncleared swap margin collateral segregation provides that, among other things:

Prior to execution of a swap, the SD or MSP must give notice to its counterparty that it may request segregation of its posted initial margin. Notice must be given to an officer of the counterparty that is responsible for collateral management, a chief risk officer or the CEO, depending on availability.
Segregated initial margin must be entrusted to one or more custodians that are legal entities separate and independent from both the SD or MSP and the counterparty.
Segregated margin must be held in an account for and on behalf of the counterparty, which may also hold variation margin if the parties agree (although there is no requirement that an SD or MSP segregate variation margin for uncleared swaps; to do so is expensive and presents logistical challenges).
The custodian must be a party to any agreement to segregate margin, and the agreement must state that:
- to withdraw margin, both the SD or MSP and the counterparty must agree;
- notice must be given to the non-withdrawing party immediately upon withdrawal; and
- the custodian may remit segregated margin funds without written consent of both parties if it is provided with a written statement from one party, made under oath or penalty of perjury, that the parties have agreed that the withdrawing party is entitled to the funds.
The SD or MSP must maintain a record of its receipt of the notification from the counterparty and whether the counterparty has elected or declined to have its posted initial margin collateral segregated.
An SD or MSP must give notice to its counterparty only one time in a given calendar year. Once notice has been given, notice need not be given on subsequent swaps entered into by the same parties. A counterparty may change its election to segregate its initial margin collateral at any time. Upon notice that a counterparty elects to have its initial margin collateral segregated, the SD or MSP must segregate all initial margin collateral with respect to all subsequent swaps entered into by the parties in that calendar year.
Segregated initial margin must be invested consistent with Part 23 Section 1.25 of the CFTC Regulations, which governs the investment of the property of exchange-traded futures customers. Subject to the requirements of Section 1.25, the parties may make commercial arrangements providing for the investment of margin and allocation of gains and losses as they see fit. For details on acceptable investments under Regulation 1.25, see Practice Notes, The Dodd-Frank Act: Derivatives Margin Collateral Rules: Investment of Customer Funds and Cleared Swaps Customer Collateral.

The final rule does not limit eligible collateral, that is, the types of margin collateral that a customer may post.

Note that although the final rule provides uncleared swaps counterparties of SDs and MSPs with this protection, it is a protection that few counterparties will take advantage of. In many cases, the segregated custodial arrangement is prohibitively expensive for the counterparty.

Expansion of "Customer Property" and "Customer" definitions. As part of the same rulemaking, the CFTC also expanded the definition of "customer property" under CFTC Regulation Part 190 to provide cleared swap portfolio margining arrangements with the same protections in a commodity broker liquidation under subchapter IV of chapter 7 of the Bankruptcy Code as are already afforded futures portfolio margining arrangements. In connection with this, the CFTC:

Expanded the definition of "customer property" under Part 190 of the CFTC regulations to explicitly deem as customer property securities held in a portfolio margining account carried as a futures account or a cleared swaps customer account. Under Part 190 of existing CFTC Regulations, segregated cash and securities posted as margin are customer property (defined in Section 761 of the Bankruptcy Code) for the purposes of the commodity-broker provisions of the Bankruptcy Code. These accounts are therefore not subject to an SD, MSP or custodian bankruptcy proceeding or other receivership.
Amended the definition of "customer" under CFTC Regulation 190 to include the owners of these accounts for the purposes of the commodity broker provisions of the Bankruptcy Code.

Portfolio margining refers to net collateral posting over a portfolio of transactions. Rather than posting collateral to cover exposure under each individual transaction, the positions are netted across transactions and collateral calls made on that basis (see Practice Note, Practical Guide to Counterparty Collateral Negotiation: Net (Portfolio) Margining versus Gross Margining). These changes are designed to facilitate the recovery of posted margin by customers in the event of a bankruptcy of the SD, MSP or custodian.

Compliance dates:

For uncleared swap transactions that are entered into with ‘‘new counterparties" (swaps entered into on or after January 6, 2014) compliance with the initial margin segregation rules is required no later than May 5, 2014.
For uncleared swap transactions that are entered into with ‘‘existing counterparties’’ (swaps entered into before January 6, 2014) compliance with the initial margin segregation rules is required no later than November 3, 2014.
All parties must comply with the Part 190 rules that address ownership of segregation accounts and bankruptcy by January 6, 2014.

Also on October 30, the CFTC released final rules on segregation of customer funds and margin posted in connection with futures contracts (see Legal Update, Final Rules on Protection of FCM Customer Funds Adopted by CFTC).

For information on margin segregation requirements for cleared swaps, see Legal Update, Final Rules on Protection of FCM Customer Funds Adopted by CFTC.

For details on SDs and MSPs, see Practice Note, Is Your Client a Swap Dealer or Major Swap Participant?

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