Protection of Collateral for Uncleared Swaps-the significance of Initial Margin Segregation

On November 6, 2013, the U.S. Commodity Futures Buying and selling Commission (“CFTC”) printed final rules that need swap dealers and major swap participants (“Registered Entities”) to inform finish-customers of the to require segregation of initial margin for uncleared swaps (the “Final Rules”). [1] The Ultimate Rules give finish-customers more bargaining power within the settlement of swaps margin terms with Registered Organizations and can minimize the probability of another Lehman Siblings scenario by which finish-user collateral was hard to identify, trace, and recover.

Uncleared Swaps and Collateral

Regardless of the proceed to central clearing well over-the-counter (“OTC”) derivatives, uncleared OTC derivatives continue being broadly used risk management tools for companies, pension funds, insurance providers, banking institutions, and limited option organizations utilized in securitizations. Without uncleared swaps, customers of those items can experience greater earnings unpredictability because of an lack of ability to be eligible for a hedge accounting, or perhaps be not able to counterbalance the rate of interest, inflation, and durability risks resulting from lengthy-dated pension or insurance liabilities. Government bodies, both domestically and abroad, have suggested rules recommending the exchange of margin for uncleared swaps by certain groups of finish-customers and also have lengthy recognized the significance margin has within the decrease in systemic risk. [2]

Collateral can be a key mitigant of counterparty risk both in removed and uncleared swaps. Collateral includes margin that’s published with time to pay for the present exposure developing from changes on the market worth of the positioning because the trade was performed or even the previous time the positioning was marked-to-market (“Variation Margin”) and initial margin, that is moved in the start of the transaction like a performance bond to pay for potential future exposures developing from changes on the market worth of the positioning (“Initial Margin”). In the past, most collateral plans under bilateral uncleared swaps were one-way obligations for finish-customers but with time have developed into two-way obligations where Variation Margin is exchanged by both sides within the existence from the swap. Using Initial Margin, however, has largely continued to be a 1-way obligation for finish-customers, mainly enforced by swap dealers like a cushion against residual credit risk that could exist even within collateralized buying and selling agreement. This over-collateralization is intentional it’s a market practice that developed in line with the role swap dealers play in derivatives trades as well as their relative credit rating. However, any situation by which one party has shipped collateral more than the loan exposure borne through the other party signifies additional risk when another party becomes insolvent. As recent occasions demonstrate, most particularly the collapse of Lehman Siblings, this isn’t just hypothetical risk. Steps can automatically get to mitigate or eliminate these risks.

CFTC Final Rules on Protection of Initial Margin for Uncleared Swaps
Statutory Background
Section 4(s)(l) of the Commodity Exchange Act (the “CEA”) requires that a Registered Entity (i) notify each end-user at the beginning of a swap transaction that the end-user has the right to require segregation of its Initial Margin (the “Notice Requirement”) and (ii) segregate the Initial Margin at the request of the end-user (the “Segregation Requirement”).

Notice Requirement
Section 23.701 of the Final Rules implements the Notice Requirement and requires that a Registered Entity, prior to the execution of each uncleared swap:

  • Notify an appropriate officer of the end-user that it has the right to require that any Initial Margin it provides in connection with such swap be segregated in accordance with sections 23.702 and 23.703 of the Final Rules; [3]
  • Identify one or more custodians, one of which must be a creditworthy non-affiliate and each of which must be a legal entity independent of both parties to the swap, as acceptable depositories for segregated Initial Margin; [4] and
  • Provide information regarding the price of segregation for each such custodian to the extent the Registered Entity has such information.

This notification should be supplied by an authorized Entity to the finish-customers at least one time per twelve months (unless of course the Registered Entity doesn’t enter a swap using the finish-user throughout a given twelve months). An finish-user may, in the discretion, change its election to want or otherwise to want segregation of Initial Margin by delivering written notice towards the Registered Entity, which altered election would affect all swaps joined into between your parties after such notice is shipped.

Segregation Requirement
If an end-user elects to segregate its Initial Margin, section 23.702 of the Final Rules requires that:

  • The custodian holding the Initial Margin segregated pursuant to such an election must be a legal entity “independent” of both the Registered Entity and the end-user; and
  • Initial Margin segregated pursuant to such an election must be held in an account segregated for and on behalf of the end-user and designated as such (which account may, if both parties agree, also hold Variation Margin).

The CFTC has indicated that segregation should become effective upon election, not upon completion of custodial documentation. [5]

Section 23.702 of the Final Rules further requires that any agreement for the segregation of margin must (i) be in writing, (ii) include the custodian as a party, and (iii) provide that:

  • Any withdrawal of such margin other than pursuant to a “turnover of control” of such margin (described below) may be made only by agreement of both parties and notification thereof must be provided immediately to the non-withdrawing party; or
  • The custodian will turn over control of such margin to the end-user or to the Registered Entity, promptly upon presentation to it of a statement in writing, made under oath or under penalty of perjury as specified in 28 U.S.C. 1746, by an authorized representative of either such party, stating that this party is entitled to such control pursuant to an agreement between the parties (and the other party must be immediately notified of such turnover). [6]

Investment of Segregated Margin

Section 23.703(a) provides that margin for uncleared swaps that’s segregated pursuant for an election under section 23.701 may be invested in line with CFTC regulation 1.25. [7] Susceptible to this, the parties may enter any written commercial arrangement, concerning the investment of these margin and also the allocation of resulting gains and deficits. The CFTC acknowledges this standard can lead to lower investment returns, however it stresses the significance of safeguarding collateral and mitigating the systemic risk that may derive from losing use of such collateral.

The CFTC offers useful clarification in which the parties for an uncleared swap have decided to segregate both Initial Margin and Variation Margin. In such instances, margin amounts might be commingled and locked in exactly the same account, but towards the extent the parties accept commingle segregated Initial Margin and Variation Margin, the needs established in sections 23.700 through 23.704, such as the investment limitations in section 23.703(a) (as described within this alert), would affect all margin locked in such account.

Requirements for Non-Segregated Margin

Section 4s(l)(4) from the CEA mandates that if the finish-user selects to not require segregation, the Registered Entity must are accountable to the finish-user, on the quarterly basis, the back-office methods from the Registered Entity relevant to margin and collateral needs have been in compliance using the agreement from the parties. [8]

Section 23.704 implements this legal provision by needing the main compliance officer of the Registered Entity to are accountable to each finish-user that selects to not require segregation of Initial Margin pursuant to section 23.701(a), no after the 15th working day of every calendar quarter, on if the Registered Entity’s back-office methods relevant to margin and collateral needs were, at any time throughout the previous quarter, not in compliance using the agreement from the parties. This obligation is applicable regarding each Registered Entity no sooner than the 90th calendar next day of the date which the very first swap is transacted between your finish-user and also the Registered Entity.

The CFTC acknowledges within the release that finish-customers might want to segregate in certain lesser manner than that considered by section 23.702, while some may not segregate whatsoever. Either in situation, where an finish-user for an uncleared swap doesn’t want to require segregation of Initial Margin in compliance with section 23.702, the Registered Entity must adhere to this confirming requirement.

Compliance Dates
The Final Rules were published in the Federal Register on November 6, 2013, and became effective on January 6, 2014 (the “Effective Date”). The specific compliance dates are the following:

  • Where no agreement (e.g., an ISDA Master Agreement) exists between the Registered Entity and the end-user concerning uncleared swaps on the Effective Date (i.e., for transactions involving “new counterparties”), the Registered Entity must be in compliance with the Final Rules with respect to that swap no later than May 5, 2014; and
  • Where an agreement already exists between the Registered Entity and the end-user on the Effective Date (i.e., for transactions involving “existing counterparties”), the Registered Entity under an uncleared swap must be in compliance with the Final Rules with respect to that swap no later than November 3, 2014.

It ought to be noted, however, the Final Rules don’t affect swaps joined into before the Effective Date. Finish-customers who would like to avoid potential buying and selling disruptions should be ready to react to notices from Registered Organizations before the relevant compliance date.

ISDA Market Advisory and CFTC IM Segregation Right Notice

On March 13, 2013, the Worldwide Swaps and Derivatives Association (“ISDA”) launched an advisory note to improve understanding of approaching dates and obligations underneath the Final Rules. [9] The advisory note features a form that market participants may use to transmit the needed collateral management contact details to Registered Organizations and tells parties of the obligations underneath the Final Rules, particularly the necessity to establish compliant segregation plans (in order to modify existing plans).

On March 27, 2014, ISDA printed the “CFTC IM Segregation Right Notice” and associated “Frequently Requested Questions.” [10] These documents usually are meant to assist market participants in applying the ultimate Rules, particularly the requirement of Registered Organizations to inform finish-customers of the to require segregation of Initial Margin for uncleared swaps.

ISDA and Markit are supplying additional tools on ISDA Amend to help market participants in designating collateral management contact details, delivering/finding the relevant notices regarding the authority to Initial Margin segregation, verifying receipt of these notices, and making elections regarding whether or not to segregate Initial Margin. The ISDA Amend tool for designating and delivering collateral management contact details to Registered Organizations is presently readily available for use, as the functionality for delivery/delivery of the relevant notices regarding the authority to Initial Margin segregation, confirmations of receipt and communication of segregation elections have been in development and therefore are expected to be shown at the end of April 2014. These power tools is going to be available free of charge to non-dealer market participants.

Practical Considerations for the End-User
Whether as a result of the credit quality of the end-user, the type of account or vehicle entering into the swap, the type of underlying exposure being taken, or the volatility of the swap, providing excess collateral to Registered Entities exposes end-users to additional risks.

Risk to End-Users Posting Initial Margin
While a swap dealer that imposes Initial Margin will take advantage of the resulting buffer of more collateral, the finish-user assumes additional chance of loss in case the swap dealer becomes insolvent.

Inside a swap dealer insolvency, if the finish-user shipped Initial Margin straight to the swap dealer and also the swap dealer either rehypothecated the margin or commingled the margin using its own assets, the finish-user might have an over-all unsecured claim for that recovery of these margin and could be titled to some pro rata distribution together with other general unsecured creditors. This kind of claim ranks behind other creditor claims of greater priority, and therefore in lots of insolvencies general unsecured creditors get compensated under 100 % of the claim amount. It was the situation within the Lehman Siblings insolvency. Finish-customers to swaps having a Lehman Siblings entity where Initial Margin wasn’t segregated or provided any client resource protections were uncovered to deficits because, following Lehman’s personal bankruptcy filing, claims for that return of money and investments published to satisfy Initial Margin needs were treated as general unsecured claims around the debtor’s estate.

Should I Elect to Segregate Initial Margin?
There are a number of things to consider that increase the complexity from the question however, there’s little question that third-party custodial segregation of Initial Margin may be the safest arrangement for that finish-user.  Despite the fact that, there are several disadvantages.

Cost of Segregation
Like a practical matter, the price of segregation will probably include (i) the custodian’s charges, and (ii) greater transaction charges or charges enforced through the swap dealer caused by its lack of ability to re-make use of the margin (since rehypothecation through the swap dealer within third-party custodial arrangement is usually difficult). Oftentimes, the expense connected with negotiating a segregation arrangement may render the swap prohibitively costly for that finish-user. The finish-user will have to see whether the advantages into it of these an agreement justify the greater transaction costs.

Segregation Arrangements (i.e., tri-party agreements)

The Ultimate Rules require third-party custodial relationship to become recorded inside a written agreement. The segregated margin could be launched to 1 party or another either (i) upon the agreement of both finish-user and also the Registered Entity, or (ii) upon an itemized statement by one party that such party is titled to manage from the Initial Margin under a contract between your finish-user and also the Registered Entity. The statement should be signed through the party’s approved representative “under penalty of perjury.” The necessity the written statement be “under penalty of perjury” is definitely an make an effort to balance the necessity of the parties to get the margin rapidly in certain conditions (for instance, in case of a default) and the necessity to safeguard against improper demands to get into the margin.

Figuring out the conditions to which the custodian may adhere to an finish-user request return of margin will probably be an item of contention between your Registered Entity and also the finish-user. The finish-user shouldn’t think that its margin is going to be came back when the finish-user claims the Registered Entity has defaulted. When the Registered Entity challenges the finish-user’s default determination, it may be a while before the problem is resolved. In that time, the client may not need its margin.

ISDA has lengthy attempted to harmonize practices within the swaps market by creating some “best collateral practices” meant to mitigate risks natural within the collateral management process also to set anticipations and standards for brand new entrants towards the swaps market. [11] Within this publication, ISDA promotes using “standardized industry documentation” to “promote market convergence towards common standards”. [12] In recognition of the principle, ISDA printed the ISDA 2013 Account Control Agreement (the “ISDA ACA”) to facilitate the settlement procedure for contractual plans that offer for segregation of Initial Margin with a 3rd party custodian. [13] Much like other tri-party account control contracts, the ISDA ACA is really a three-way contract between your custodian, an finish-user, and presumably a swap dealer, also it provides the custodian holds and release Initial Margin to some asking for party according to pre-defined conditions. The ISDA ACA includes a similar structure towards the ISDA Master Agreement. It aims to streamline discussions for segregation plans by providing a standardized agreement by having an associated annex that contains recommended optional provisions that may be tailored as appropriate. As the ISDA ACA matches regulating needs, the provisions and/or annexes aren’t necessary or appropriate under all conditions. The writer was associated with ISDA in the introduction of predecessor terms and provisions addressing the segregation of margin and it has assisted market participants address these and other alike issues.

Initial Margin versus Variation Margin
Like a general matter, segregation is simpler to apply and manage regarding Initial Margin than Variation Margin. Variation Margin constantly changes and frequently flows backwards and forwards between your parties of an every day basis, which makes it administratively hard to segregate. However, the ultimate Rules don’t stop the segregation of Variation Margin, and parties should consider if the arrangement should affect all margin or only Initial Margin. This method could be more cost-effective but still safeguard Initial Margin.

Custodian Risk
While somewhat outdoors the scope from the Final Rules, segregation plans will also be susceptible to the chance of a custodian default. Organizations supplying such services are usually susceptible to special rules or structure their business models in a way regarding prevent their default in the outlook during parties entrusting assets for their care. As noted in footnote 4, the ultimate Rules don’t stop affiliates of the Registered Entity from becoming custodian. There’s a danger, however, that affiliated parties are experiencing contemporaneous insolvency, even when they’re individually run and also have different business models and/or regulating oversight regimes. Finish-customers should consider performing an entire risk assessment before choosing a custodian to carry segregated margin.

Timing
New finish-customers should consider whether you will see the required time to supply Registered Organizations using their collateral management contact details and segregation election before the May 5, 2014 compliance date. Regardless of the accessibility to tools on ISDA Amend, the entire suite of tools continues to be in development along with a new finish-user might be instructed with a Registered Entity to provide its confirmation and election straight to such Registered Entity (instead of through ISDA Amend) to prevent any trade disruptions on or after May 5, 2014.

Conclusion
Uncleared swaps are and will also be sought after by a number of companies, energy companies, investment managers, pension funds, government authorities, and banking institutions to hedge their risks. The heads of condition from the G-20 nations have known as for government bodies to plot plans to enhance margin plans within the uncleared swaps market and also the global regulating community has responded. Although using Initial Margin is a vital tool for systemic resilience, the Lehman experience has brought for an elevated understanding of the potential risks connected with posting Initial Margin. Finish-customers considering collateral plans that contains Initial Margin terms might want to carefully assess the risks, costs, restrictions, and effectiveness associated with a Initial Margin holding structure.

Notes:
[1] Protection of Collateral of Counterparties to Uncleared Swaps; Treatment of Securities in a Portfolio Margining Account in a Commodity Broker Bankruptcy, 78 Fed. Reg. 66621 (Nov 6, 2013) (adopting CFTC regulations 23.700-23.704)

[2] For a discussion of the continuing importance of  uncleared swaps, see the attached article from the K&L Gates 2014 Global Government Solutions Annual Report, which is available at: http://media.klgates.com/klgatesmedia/epubs/GGS_2014/ (p. 81)

[3] CFTC Regulation 23.700 indicates that to “segregate” two or more items is to keep them in separate accounts and to avoid combining them in the same transfer between two accounts (see 78 Fed. Reg. at 66636.).

[4] In the adopting release, the CFTC clarifies that “The language of the statute does not require that affiliates of a counterparty be prohibited from serving as the custodian for segregated funds. However, in light of the correlated insolvency risk wherein if an SD or MSP becomes insolvent its affiliates will have an elevated risk of also becoming insolvent, the Commission has determined that an SD or MSP should be required to provide the counterparty with at least one credit worthy non-affiliate as an option to serve as the custodian.” (see 78 Fed. Reg. at 66627.)

[5] Id. at 66627.

[6] In the adopting release, the CFTC noted that it “believes that a perjury standard is appropriate because it mitigates the tradeoff between speed and accuracy in stress situations. In circumstances where one party to a swap needs expedient turnover of segregated margin (for example, in order to meet margin calls on positions hedging the swap) and is unable to obtain timely approval from the counterparty (e.g., if margin is being taken from the account because the counterparty is in financial trouble), it is important for a depository to be able to respond to a unilateral request for collateral without having to take the time to independently investigate the legitimacy of the request.  At the same time, circumstances of market stress may also create incentives for parties to illegitimately withdraw collateral from a segregated account. The perjury standard acts as a check on the legitimacy of a demand for collateral without requiring the time needed for an independent inquiry by the depository.” (see id. at 66627.)

[7] Regulation 1.25 establishes a general prudential standard used in the futures and cleared swaps markets that requires all permitted investments of customer segregated funds to be “consistent with the objectives of preserving principal and maintaining liquidity.”

[8] 7 U.S.C. 6s(l)4.

[9] Available at: http://www2.isda.org/functional-areas/infrastructure-management/collateral/

[10] Available at: http://www2.isda.org/functional-areas/infrastructure-management/collateral/

[11] “2013 Best Practices for the OTC Derivatives Collateral Process” available at: http://www2.isda.org/functional-areas/infrastructure-management/collateral/

[12] Id. at 7.

[13] Available at: http://www2.isda.org/functional-areas/infrastructure-management/collateral/