CFTC Re-Proposes Capital Rules for Non-Bank Swap Dealers

Transcription

1 CFTC Re-Prpses Capital Rules fr Nn-Bank Swap Dealers January 20, 2017 The Cmmdity Futures Trading Cmmissin ( CFTC ) has re-prpsed capital, liquidity and financial recrdkeeping and reprting rules (the Prpsed Rule ) 1 fr swap dealers ( SDs ) and majr swap participants ( MSPs ) that are nt subject t capital rules f a Prudential Regulatr ( nnbank SDs and MSPs ). 2 The Prpsed Rule als wuld amend the CFTC s capital rules fr futures cmmissin merchants ( FCMs ), including t address SDs dually registered as FCMs. Under the Prpsed Rule: (1) a nnbank SD that is nt an FCM culd elect t apply a mdified versin f the risk-weighted capital requirements applied by the Bard f Gvernrs f the Federal Reserve System ( FRB ) t U.S. bank hlding cmpanies; (2) alternatively, a nnbank SD that is nt an FCM culd elect t apply a mdified versin f the capital requirements that the Securities and Exchange Cmmissin ( SEC ) has prpsed t apply t a security-based swap dealer ( SBSD ) that des nt have a Prudential Regulatr (a nnbank SBSD ) as part f its 2012 capital, margin and segregatin prpsal (the SEC Prpsal ); 3 If yu have any questins cncerning this memrandum, please reach ut t yur regular firm cntact r the fllwing authrs New Yrk Edward J. Rsen ersen@cgsh.cm Clin D. Llyd cllyd@cgsh.cm Igr Kleyman ikleyman@cgsh.cm Christina Obiajulu cbiajulu@cgsh.cm Truc Dan tdan@cgsh.cm (3) a nn-financial SD culd elect t apply a tangible net wrth apprach t capital requirements, under which market and credit risk charges wuld nly apply t certain swap-related psitins; and (4) a dually registered SD/FCM wuld be subject t a mdified versin f the existing FCM net capital rule Fed. Reg. 91,252 (Dec. 16, 2016). The Prpsed Rule is a re-prpsal f capital rules initially prpsed by the CFTC in May See 76 Fed. Reg (May 12, 2011). 2 The Prpsed Rule als includes a limited range f financial recrdkeeping and reprting requirements fr SDs and MSPs that are subject t capital rules f a Prudential Regulatr ( bank SDs and MSPs ) Fed. Reg (Nv. 23, 2012). clearygttlieb.cm Cleary Gttlieb Steen & Hamiltn LLP, All rights reserved. This memrandum was prepared as a service t clients and ther friends f Cleary Gttlieb t reprt n recent develpments that may be f interest t them. The infrmatin in it is therefre general, and shuld nt be cnsidered r relied n as legal advice. Thrughut this memrandum, Cleary Gttlieb and the firm refer t Cleary Gttlieb Steen & Hamiltn LLP and its affiliated entities in certain jurisdictins, and the term ffices includes ffices f thse affiliated entities.

2 By incrprating FRB and SEC requirements, the Prpsed Rule culd ptentially prvide relief fr registrants subject t multiple prudential supervisin regimes. Even s, the Prpsed Rule raises a number f significant issues: 8 Percent IM Rule: Each f the appraches in the Prpsed Rule wuld, t varying extents, establish minimum capital requirements based n 8 percent f the sum f an SD s initial margin fr its psitins in futures, cleared swaps, uncleared swaps, cleared security-based swaps and uncleared security-based swaps (the 8 Percent IM Rule ). This requirement, like parallel requirements in the existing FCM net capital rule and the SEC Prpsal, is intended t ensure that the level f a registrant s capital increases with the risks f its expsures. Hwever, because the sum f initial margin amunts fr the relevant psitins is nt an accurate prxy fr an SD s aggregate risk prfile, the prpsed 8 Percent IM Rule wuld require a registrant t maintain resurces far in excess f the actual risks presented by its expsures; Standalne Liquidity Requirements: The Prpsed Rule wuld apply standalne liquidity requirements t subsidiaries within a bank hlding cmpany grup, which wuld cnstrain a bank hlding cmpany s ability t manage liquidity acrss entities and deply resurces as necessary in a stress scenari. In particular, the liquidity requirements applicable t a nnbank SD applying the SEC Prpsal r a dually registered SD/FCM wuld inhibit grup-wide liquidity management by restricting the intraday use f liquidity and limiting the range f assets eligible t satisfy liquidity requirements t unencumbered cash and U.S. gvernment securities; Intersectin f Capital and Margin Requirements: Unlike the margin rules in the SEC Prpsal, the CFTC s margin rules require a registrant bth t cllect and pst initial margin, require initial margin t be segregated with a third-party custdian, and incrprate a multi-year initial margin implementatin schedule (with an accmpanying increase in the extent f grandfathered legacy psitins). T accmmdate these differences, the Prpsed Rule wuld mdify certain aspects f the SEC Prpsal and existing FCM net capital rule, such as eliminating 100 percent capital charges fr initial margin that an SD psts when the margin is segregated at a third-party custdian. The Prpsed Rule des nt, hwever, clearly address certain ther cntrversial elements f the SEC Prpsal, such as capital charges fr legacy accunts that are nt subject t margin requirements and initial margin cllected frm a cunterparty but segregated at a third-party custdian. If applied t swap psitins cvered by the CFTC s margin rules, these capital charges wuld be highly prblematic due t the differences between the CFTC s and SEC s margin rules nted abve. Cncerns regarding these issues were raised in cmments n the SEC Prpsal, but the Prpsed Rule des nt seek t address cmmenters cncerns r cnsider the alternative appraches they prpsed. As the CFTC mves frward, it will be imprtant fr it t crdinate with the SEC in addressing these issues, as well as the many technical issues raised by the Prpsed Rule. Otherwise, capital and liquidity requirements stand likely t intrduce unwarranted cmpetitive disparities, which wuld lead t further cncentratin and reduced liquidity within the swap and security-based swap markets. This Memrandum prvides an verview f the Prpsed Rule and summarizes the key issues that it raises. Cmments n the Prpsed Rule are due by March 16,

3 SCOPE OF THE PROPOSED RULE The Prpsed Rule wuld apply t nnbank SDs and MSPs, including a nnbank SD that is dually registered with the CFTC as an FCM r that will register with the SEC as an SBSD. On the ther hand, the Prpsed Rule wuld nt apply capital requirements t a bank SD r MSP, althugh a bank SD r MSP wuld remain subject t a limited range f financial recrdkeeping and reprting requirements. 4 A nnbank SD r MSP that is rganized and dmiciled utside the United States (a Nn-U.S. SD r MSP ), including ne that is an affiliate f a persn rganized and dmiciled in the United States, culd satisfy the requirements f the Prpsed Rule by substituting cmpliance with crllary hme cuntry requirements that the CFTC has affirmatively determined t be cmparable t the CFTC s requirements. SD CAPITAL AND LIQUIDITY REQUIREMENTS As nted abve the Prpsed Rule cntains fur different appraches t calculating an SD s minimum capital requirements: (1) a Bank-Based Apprach, which wuld incrprate certain aspects f the FRB s capital and liquidity requirements fr U.S. bank hlding cmpanies; (2) a Net Liquid Assets Apprach, which wuld incrprate certain aspects f the SEC Prpsal s capital and liquidity requirements fr nnbank SBSDs; (3) a Tangible Net Wrth Apprach, which wuld be available nly t an SD that is predminantly engaged in nn-financial activities (a Nn-Financial SD ); 5 and (4) an FCM Apprach, which wuld apply a mdified versin f the CFTC s existing FCM net capital requirements t all SDs that are dually registered as FCMs. A dually registered SD/FCM wuld als be required t satisfy the liquidity requirements applicable t a nnbank SD that elects the Net Liquid Assets Apprach. Any nnbank SD that is nt dually registered as an FCM wuld be permitted t elect either the Bank-Based Apprach r the Net Liquid Assets Apprach, regardless f whether it is part f a U.S. bank hlding cmpany r dually registered as an SBSD. On the ther hand, even if a nnbank SD has access t internal risk mdels that have been apprved by the FRB, the SEC r a freign financial regulatr, it wuld nt be permitted t use thse mdels t calculate its CFTC capital requirements unless it received separate apprval frm the CFTC r the Natinal Futures Assciatin ( NFA ). The CFTC has requested cmment n measures that might mitigate the implementatin burden assciated with this duplicative mdel apprval prcess, such as permitting an SD t use mdels n a prvisinal basis if anther regulatr has apprved them. The fllwing cmparisn chart summarizes these different appraches, including the type f capital required t satisfy minimum capital requirements and the applicatin f the 8 Percent IM Rule, market and credit risk charges, and liquidity requirements. 4 Under the Ddd-Frank Act, the FRB is the Prudential Regulatr fr an SD r MSP that is a freign bank that des nt perate an insured branch in the U.S. Accrdingly, the FRB s 2015 margin and capital rulemaking cvered such an SD r MSP. Hwever, the FRB did nt, as part f that rulemaking, adpt any capital rules fr such an SD r MSP. The rule text prpsed by the CFTC is nt drafted in a manner that accunts fr this aspect f the FRB s rulemaking, thus raising questins abut hw the CFTC wuld treat them. 5 An SD wuld qualify as a Nn-Financial SD if: (1) its cnslidated annual grss financial revenues in either f its tw mst recently cmpleted fiscal years represent less than 15 percent f its cnslidated grss revenue in that fiscal year; and (2) its cnslidated ttal financial assets at the end f its tw mst recently cmpleted fiscal years represent less than 15 percent f its cnslidated ttal assets as f the end f the fiscal years. 3

4 Capital Apprach Eligible Nnbank SDs Cmparisn f Nnbank SD Capital Appraches Type f Capital Minimum Capital Requirement Liquidity Requirements The greater f: (A) $20 millin; Bankbased Apprach Any nnbank SD that is nt registered as an FCM Cmmn equity tier 1 capital (B) 8 percent f the SD s risk-weighted assets, cmputed as thugh the SD were itself a bank hlding cmpany subject t the FRB s cnslidated capital requirements, with market and credit risk charges calculated using either: (i) standardized (a) credit risk charges in accrdance with the FRB s requirements in subpart D f 12 C.F.R. part 217 and (b) market risk charges in accrdance with the CFTC s FCM net capital rule, with thse charges multiplied by a factr f 12.5 (s as t ensure that the SD maintains capital at least equal t the full market risk charge, after multiplying its risk-weighted assets by 8 percent); r The FRB s Liquidity Cverage Rati ( LCR ) requirements fr bank hlding cmpanies applied t the SD as thugh it were itself a bank hlding cmpany, subject t certain adjustments fr cash depsited with banks and assets maintained by a Nn-U.S. SD in its hme cuntry jurisdictin (ii) CFTC/NFA-apprved internal mdels; (C) the 8 Percent IM Rule; r (D) capital requirements established by the NFA 4

5 Capital Apprach Net Liquid Assets Apprach Eligible Nnbank SDs Any nnbank SD that is nt registered as an FCM Cmparisn f Nnbank SD Capital Appraches Type f Capital Minimum Capital Requirement Liquidity Requirements Net capital, as thugh the SD were a nnbank SBSD subject t the SEC Prpsal, but subject t certain adjustments in relatin t market and credit risk charges and the treatment f initial margin psted with a third-party custdian The greater f: (A) $20 millin; 6 (B) the 8 Percent IM Rule; r (C) capital requirements established by the NFA The greater f: A liquidity stress test based n the stress test included in the SEC Prpsal (the Liquidity Stress Test ) Tangible Net Wrth Apprach Only Nn- Financial SDs Tangible net wrth, i.e., net wrth under U.S. GAAP, excluding gdwill and ther intangible assets, and marking lng and shrt psitins in swaps, security-based swaps and related psitins t market (A) $20 millin plus market and credit risk charges fr the SD s swap and related hedge psitins that are part f its swap dealing activities, cmputed using either the standardized charges in the CFTC s FCM net capital rule r using internal mdels apprved by the CFTC r NFA; (B) the 8 Percent IM Rule; r Nne (C) capital requirements established by the NFA The greater f: FCM Apprach Only Dually- Registered FCM/SDs Adjusted net capital, as cmputed under the existing FCM net capital rule, subject t certain adjustments (A) $20 millin; (B) the 8 Percent IM Rule; r The Liquidity Stress Test (C) capital requirements established by the NFA 6 If an SD electing the Net Liquid Assets apprach was apprved t use internal mdels t cmpute its market and credit risk charges, then it wuld als be required t maintain tentative net capital (i.e., net capital befre deductins fr market and credit risk charges) f at least $100 millin. Higher net capital and tentative net capital requirements wuld als apply under the SEC Prpsal if the entity was registered as a brker-dealer. 5

6 8 Percent IM Rule The 8 Percent IM Rule wuld set minimum capital requirements fr an FCM r nnbank SD equal t 8 percent f the initial margin required fr the SD s psitins in futures, cleared swaps, uncleared swaps, cleared security-based swaps, and uncleared security-based swaps. The 8 Percent IM Rule wuld build n the existing FCM net capital rule, which requires an FCM t maintain net capital in excess f 8 percent f the risk margin requirement fr cleared swaps and futures psitins carried by the FCM fr custmers and affiliates, and the SEC Prpsal, which wuld require a nnbank SBSD t maintain net capital in excess f 8 percent f the risk margin amunt fr cleared security-based swaps carried by the SBSD fr custmers and uncleared security-based swaps entered int by the SBSD. The Prpsed Rule wuld, hwever, g further than these existing rules in several key respects: The 8 Percent IM Rule wuld apply t the sum f the initial margin requirements fr all the relevant psitins, rather than t the greater f the initial margin requirements fr psitins in CFTC-regulated instruments, n the ne hand, and psitins in SEC-regulated instruments, n the ther hand. Unlike the existing FCM net capital rule, the 8 Percent IM Rule wuld cver initial margin fr uncleared swaps, calculated n a cunterparty-by-cunterparty basis under the CFTC s margin rules. This calculatin wuld need t include initial margin fr certain uncleared transactins that are nt subject t initial margin requirements under the CFTC s margin rules, such as legacy uncleared swaps, exempt freign exchange ( FX ) swaps and exempt FX frwards, uncleared inter-affiliate swaps and uncleared swaps with nn-financial end users This calculatin wuld als include initial margin threshld amunts and minimum transfer amunts. The 8 Percent IM Rule wuld similarly cver initial margin fr uncleared security-based swaps, withut regard t any exemptins r exclusins adpted by the SEC. 7 Unlike bth the existing FCM net capital rule and the SEC Prpsal, the 8 Percent IM Rule wuld cver prprietary psitins in cleared swaps and cleared security-based swaps. 8 Als, fr nnbank SDs ther than FCMs, the 8 Percent IM Rule wuld cver prprietary futures psitins. 9 SD/FCMs wuld als cntinue t need t include initial margin in respect f nn-prprietary cleared swap psitins, i.e., swap psitins they clear fr affiliates and custmers. The Prpsed Rule des nt address hw an SD that is nt dually registered as an SBSD, and thus wuld nt have SEC apprval t use risk-based mdels t cmpute its initial margin fr uncleared security-based swaps, wuld make this calculatin. Fr example, wuld such an SD be required t use a grid-based apprach t making the calculatin? Or culd it lk t the initial margin calculatins perfrmed by its registered SBSD cunterparties? Fr dually registered SD/FCMs (but nt ther SDs), these cmpnents f the 8 Percent IM Rule wuld include initial margin that the SD/FCM is required t pst t a brker, in additin t the initial margin it is required t pst t a clearing rganizatin. Als, dually registered SD/FCMs and Net Liquid Assets SDs wuld perfrm this calculatin based n the defined term risk margin, which makes certain adjustments fr ptins psitins that wuld nt apply under the Bank-Based r Tangible Net Wrth Appraches. Fr dually registered SD/FCMs, in cntrast, the 8 Percent IM Rule wuld nt cver prprietary psitins in futures. 6

7 In additin, SD/FCMs wuld need t include initial margin in respect f nn-prprietary cleared security-based swaps psitins, i.e., security-based swap psitins they clear fr affiliates and custmers. 10 As prpsed, the 8 Percent IM Rule wuld verstate the risk f derivatives activities in several ntable respects: Because an SD wuld be required t perfrm the relevant calculatins n a cunterparty-bycunterparty basis, the 8 Percent IM Rule wuld nt take int accunt the relatively cmmn scenari where an SD has a well-hedged prtfli acrss multiple cunterparties such that, even if they all default, cunterparties with psitins n ne side f the market cannt we mney t the SD at the same time as cunterparties with psitins n the ther side f the market. This aspect f the 8 Percent IM Rule culd well induce SDs t limit the number f cunterparties with whm they deal, increasing their cunterparty cncentratin risk and reducing market cmpetitin. Althugh the CFTC has taken steps t prmte prtfli margining thrugh n-actin and exemptive relief, in mst instances the varius categries f derivatives that wuld be cvered by the 8 Percent IM Rule still must be margined separately, even if they exhibit ffsetting risk prfiles, and an SD may net the derivatives tgether upn a cunterparty s default. By establishing a capital requirement that scales up with initial margin, nt risk, the 8 Percent IM Rule wuld exacerbate the distrtins created by this aspect f the U.S. margin regime. The 8 Percent IM Rule wuld nt recgnize segregated margin as an effective credit risk mitigant. This aspect f the 8 Percent Rule is particularly startling given the criticisms that the CFTC has leveled at the Basel Cmmittee fr making the same missin in cnnectin with its supplemental leverage rati. 11 There als is n indicatin in the Prpsed Rule that the CFTC cnsiders SDs cllecting initial margin under the CFTC s margin rules t be expsed t residual cunterparty credit risk that must be addressed thrugh additinal capital charges, utside f the cntext where the CFTC s margin rules d nt require an SD t cllect initial margin (e.g., in the case f initial margin threshlds r swaps with nn-financial end users). Fr Net Liquid Assets Apprach SDs and dually registered SD/FCMs permitted t use credit risk mdels, the 8 Percent IM Rule wuld have the effect f duble-cunting ptential future credit expsure fr uncleared swaps and uncleared security-based swaps because such SDs wuld already take int accunt their ptential future credit expsure fr thse psitins as part f credit risk charges t their net capital. By including prprietary psitins in futures, cleared swaps, and cleared security-based swaps in the 8 Percent IM Rule calculatin, the Prpsed Rule wuld require significantly mre capital t be held against clearing rganizatin credit expsure than the level required fr a bank in cnnectin with its credit expsure t a qualifying central cunterparty. As a result, the Prpsed Rule wuld undercut effrts t use capital rules t 10 This aspect f the Prpsed Rule crss-references the defined terms fr custmer and nncustmer accunts. Read literally, these crss-references wuld have the effect f dublecunting initial margin fr cleared security-based swap psitins prtfli margined with cleared swap psitins in a cleared swap accunt. 11 See, e.g., Remarks f Chairman Massad befre the 3 rd Annual Derivatives Summit Nrth America, Sept. 29, 2015, available at, y/pamassad-28; Keynte Address by Chairman Massad befre the Institute f Internatinal Bankers, Mar. 2, 2015, available at, y/pamassad-13. 7

8 encurage use f cleared derivatives relative t uncleared derivatives. In additin, as the Prpsed Rule ntes, the Cmmdity Exchange Act nly cites the risk f uncleared swaps in setting standards fr capital, which des nt seem cnsistent with including prprietary psitins in cleared transactins within the 8 Percent IM Rule. Unlike under the Net Liquid Assets Apprach r the FCM Apprach, under the Bank-Based Apprach the 8 Percent IM Rule wuld nt apply cumulatively with these market and credit risk charges. Als, under the Bank-Based Apprach, unsecured receivables and lans wuld nt be subject t 100 percent capital charges like they wuld under the Net Liquid Assets Apprach r the FCM Apprach. Market and Credit Risk Charges The Prpsed Rule wuld, t varying extents, require a nnbank SD t hld capital against its market and credit risk expsures: Bank-Based Apprach. A nnbank SD fllwing the Bank-Based Apprach wuld take int accunt its market and credit risk expsures when calculating the prng f its minimum capital requirements crrespnding t 8 percent f its risk-weighted assets. T make this calculatin, the SD wuld use either (i) standardized (a) credit risk charges in accrdance with the FRB s requirements in subpart D f 12 C.F.R. part 217 and (b) market risk charges in accrdance with the CFTC s FCM net capital rule, with thse charges multiplied by a factr f 12.5 (s as t ensure that the SD maintains capital at least equal t the full market risk charge, after multiplying its risk-weighted assets by 8 percent) r (ii) mdels apprved by the CFTC r NFA. The Prpsed Rule des nt precisely address hw its rules relating t the use f market and credit risk mdels are intended t interact with the parallel prvisins f the FRB s rules that the Prpsed Rule incrprates by reference, r whether r hw the CFTC intends t apply ther aspects f the FRB s advanced appraches t capital requirements (such as peratinal risk capital requirements). 12 Net Liquid Assets Apprach. An SD fllwing the Net Liquid Assets Apprach wuld take int accunt its market and credit risk expsures as charges t its net capital, based n the SEC Prpsal. 13 Unlike under the Bank-Based Apprach, these charges wuld apply in additin t the 8 Percent IM Rule. Als, with the exceptin f receivables frm third-party custdians fr initial margin that the SD psts in accrdance with the CFTC s margin rules r parallel SEC rules, an SD electing the Net Liquid Assets Apprach wuld need t take 100 percent charges fr unsecured receivables, lans and certain ther illiquid assets, cnsistent with the SEC Prpsal. The SD wuld calculate its market and credit risk deductins in accrdance with the SEC Prpsal, 13 subject t the fllwing adjustments: 14 supervising SDs that elect the Bank-Based Apprach but are nt subsidiaries f U.S. bank hlding cmpanies). As with the Bank-Based Apprach, it is nt clear whether the CFTC wuld defer t SEC interpretatins f these requirements r develp its wn interpretatins as questins arise (particularly if thse questins arise in cnnectin with supervising SDs that elect the Net Liquid Assets Apprach but are nt registered as SBSDs). 12 It als is nt clear whether the CFTC wuld defer t FRB interpretatins f FRB rules r develp its wn interpretatins as questins arise (particularly if thse questins arise in cnnectin with 14 As drafted, the SEC Prpsal s market and credit risk deductins wuld cntinue t apply t a dually registered SD/SBSD ntwithstanding the adjustments in the Prpsed Rule. If the SEC des nt incrprate adjustments made by the CFTC s 8

9 If the SD has apprval t use mdels t cmpute its market risk charges, then it wuld be required t calculate thse charges as the sum f the value-at-risk ( VaR ) measure, stressed VaR measure, specific risk measure, cmprehensive risk measure and incremental risk measure, cnsistent with Basel 2.5 market risk requirements; If the SD has apprval t use mdels t cmpute its credit risk charges, it may use such mdels t cmpute charges fr all its swap and security-based swap transactins, nt just thse with cmmercial end users; 15 The Prpsed Rule des nt, hwever, address the SEC Prpsal s requirement fr a 100 percent capital charge in cnnectin with legacy accunts that are nt subject t margin requirements, even thugh that charge wuld nt be cnsistent with the expanded ability t use mdels t cmpute credit risk charges. A 100 percent charge fr such legacy accunts wuld als be incnsistent with the CFTC s margin rules grandfathering prvisins, at least in cnnectin with initial margin where the charge wuld nt be necessary t ffset an illiquid unsecured receivable. As nted abve, an SD may recgnize as a current asset receivables frm third-party custdians hlding initial margin that the SD psts in accrdance with the CFTC s margin rules r parallel SEC rules; 15 capital rules, dually registered SDs/SBSDs wuld be subject t the stricter f bth agencies rules. This prvisin f the Prpsed Rule crss-references a prvisin f the SEC Prpsal that sets frth the prcess fr a nnbank SBSD t apply fr apprval frm the SEC t use internal mdels. Given that a separate prvisin f the Prpsed Rule appears t envisin a separate mdel apprval prcess administered by the CFTC and NFA, it is nt clear whether the Prpsed Rule was instead intended t crss-reference the prvisin f the SEC Prpsal addressing when and hw a nnbank SBSD apprved t use internal mdels may calculate mdel-based credit risk charges. That secnd prvisin f the SEC Prpsal prvides that, fr purpses f calculating maximum ptential expsure and current expsure, a nnbank SBSD can nly take int accunt the value f cllateral it receives if the SBSD maintains physical pssessin r sle cntrl f the cllateral. It des nt seem that this cnditin shuld apply t swaps, given that (a) the CFTC s margin rules require an SD t hld initial margin it cllects at a third-party custdian and (b) as nted abve, the Prpsed Rule wuld, in the parallel cntext f initial margin psted by an SD, allw the SD t recgnize as a current asset a receivable frm a third-party custdian hlding that margin in accrdance with the CFTC Margin Rules. The Prpsed Rule des nt, hwever, address the SEC Prpsal s requirement fr a 100 percent capital charge in cnnectin with cunterparties that elect t hld their initial margin at a thirdparty custdian, even thugh such a charge wuld nt be cnsistent with the prpsed treatment f initial margin psted by an SD r the segregatin requirements f the CFTC s margin rules (which are nt mirrred in the SEC Prpsal); and An SD culd nt deduct the margin difference (as defined the SEC Prpsal) in lieu f cllecting margin fr swap r security-based swap transactins. While nt entirely clear, it appears that this prvisin f the Prpsed Rule wuld supersede a requirement in the SEC Prpsal that a nnbank SBSD take a charge fr the difference between (a) the market risk charges that the SBSD wuld incur fr cleared security-based swap psitins it carries fr thers if the SBSD instead wned thse psitins itself and (b) the margin value f cllateral in the SBSD s 9

10 accunt fr the persns fr whm it clears. It might als be the CFTC s intent t clarify that an SD must cllect margin where it is required t d s, rather than taking a capital charge in lieu f margin. Hwever, the margin difference prvisin f the SEC Prpsal crss referenced by the Prpsed Rule is inappsite t this principle, since the crss-referenced SEC prvisin addresses scenaris where the SEC Prpsal wuld nt require an SBSD t cllect (r hld) margin. Tangible Net Wrth Apprach. A Nn-Financial SD fllwing the Tangible Net Wrth Apprach wuld nly need t hld capital against market and credit risk expsures assciated with the SD s swap and related hedge psitins that are part f the SD s swap dealing activities. In cntrast, ther assets, such as buildings r ther fixed assets, culd cunt as regulatry capital at their full U.S. GAAP value, even thugh the SD culd nt quickly liquidate thse assets t cver lsses assciated with its swap dealing business. This apprach is intended t avid requiring Nn-Financial SDs t restructure their swap dealing activity int a separate legal entity that des nt hld such illiquid assets. In additin, like the Bank-Based Apprach, but unlike the Net Liquid Assets Apprach and the FCM Apprach, the Tangible Net Wrth Apprach wuld nt apply the 8 Percent IM Rule cumulatively with market and credit risk charges. In additin, the Prpsed Rule wuld amend the FCM net capital rule t (i) incrprate standardized market risk charges fr swaps and security-based swaps drawn frm the SEC Prpsal and (ii) permit an SD/FCM t apply fr CFTC r NFA apprval t use mdels t cmpute market and credit risk charges. The Prpsed Rule als wuld amend the FCM net capital rule t impse a charge fr the amunt f uncleared swap margin that the FCM has nt cllected frm a swap cunterparty, less any amunts wed by the FCM t the swap cunterparty fr uncleared swap transactins. Given that the term uncleared swap margin is defined t cver initial margin requirements fr uncleared swaps (as described abve in cnjunctin with the 8 Percent IM Rule), this amendment wuld appear t subject an FCM t capital charges in circumstances where the CFTC s margin rules d nt require the FCM t cllect margin, even if the failure t cllect margin des nt result in the FCM having an unsecured receivable. With the exceptin f prvisins permitting the use f apprved mdels t cmpute market and credit risk charges, the amendments described abve wuld als apply t an FCM that is nt registered as an SD. 16 Liquidity Requirements Bank-Based Apprach. A nnbank SD that fllws the Bank-Based Apprach wuld be required t cmply with the FRB s LCR fr bank hlding cmpanies as if the SD were a bank hlding cmpany, subject t limited mdificatins discussed belw: Under the LCR, an institutin is required t maintain high quality liquid assets ( HQLAs ) 17 As a result f these aspects f the Tangible Net Wrth Apprach, SDs fllwing this apprach are likely t have cmpetitive advantages ver SDs fllwing the Net Liquid Assets Apprach r the FCM Apprach. FCM Apprach. An SD that is dually registered as an FCM wuld be required t apply the existing FCM net capital rule, with amendments expanding the 8 Percent IM Rule, as nted abve An FCM that is dually registered as a brker-dealer and eligible t use mdels under the SEC s alternative net capital rules wuld cntinue t be eligible t use SEC-apprved mdels t cmpute its market and credit risk charges. HQLAs are liquid assets that meet certain marketability criteria and are unencumbered by liens and ther restrictins n the ability f the SD t transfer the assets. There are three categries f 10

11 at least equal t the institutin s ttal net cash utflws ver a prspective 30 calendar-day perid. An institutin s ttal net cash utflws represent its liquidity needs ver a stressed 30-day hrizn, determined in accrdance with cnservative inflw and utflw assumptins. Under the Prpsed Rule, a nnbank SD that fllws the Bank-Based Apprach wuld be subject t the LCR, prvided that: (i) any such nnbank SD wuld be allwed t include cash depsited with banks that is readily available fr withdrawal as a level 1 HQLA and (ii) a Nn-U.S. SD wuld be allwed t include HQLAs maintained in its hme cuntry jurisdictin in meeting its minimum LCR. The Prpsed Rule wuld require all nnbank SDs that fllw the Bank-Based Apprach t cmply with the LCR n an entity level, even if the SD is a member f a hlding cmpany grup that cmplies with the FRB s LCR n a cnslidated basis. This apprach culd have the effect f restricting a bank hlding cmpany s ability t manage liquidity acrss entities and deply resurces as necessary in a stress scenari. Net Liquid Assets Apprach and FCM Apprach. A nnbank SD that fllws the Net Liquid Assets Apprach r FCM Apprach wuld be required t cmply with a Liquidity Stress Test, under which the SD wuld be required t estimate cash and cllateral needs ver a perid f time under specified stressed cnditins. 18 The SD wuld then be required 18 HQLAs (level 1 and levels 2A and 2B), which are subject t haircuts and cncentratin limits. These cnditins wuld include, at a minimum: (1) a decline in creditwrthiness f the SD severe enugh t trigger cntractual credit-related cmmitment prvisins f cunterparty agreements; (2) lss f all existing unsecured funding at the earlier f its maturity r put date and an inability t acquire a material amunt f new unsecured funding; (3) the ptential fr a material net lss f secured funding; (4) the lss f the ability t prcure repurchase agreement financing fr less liquid assets; (5) the illiquidity f cllateral required by and n depsit at clearing agencies r ther entities which is nt deducted frm net wrth t maintain, at all times, liquidity reserves based n the results f the Liquidity Stress Test, in the frm f unencumbered cash and U.S. gvernment securities. Features f the Liquidity Stress Test that raised cncerns amng cmmenters n the SEC Prpsal are unchanged in the Prpsed Rule. Fr example, the Liquidity Stress Test requires an SD t maintain minimum liquidity reserves at all times. This aspect f the Liquidity Stress Test wuld limit the SD s ability t use excess liquidity intraday. In additin, the range f assets allwed t satisfy the Liquidity Stress Test is much narrwer than the assets allwed t satisfy the LCR. Tangible Net Wrth Apprach. A Nn-Financial SD that fllws the tangible net wrth apprach wuld nt be subject t any liquidity requirements. MSP CAPITAL REQUIREMENTS The Prpsed Rule wuld require an MSP that des nt have a Prudential Regulatr t maintain a psitive tangible net wrth, calculated in accrdance with U.S. GAAP, and t maintain capital required by the NFA. As a result, the Prpsed Rule wuld nt subject an MSP t the 8 Percent IM Rule r any market r credit risk charges. An MSP wuld nt be subject t any liquidity requirements. FINANCIAL RECORDKEEPING AND REPORTING REQUIREMENTS The Prpsed Rule wuld impse recrdkeeping and reprting bligatins n all SDs and MSPs, including, t a limited extent, bank SDs and MSPs. r which is nt funded by custmer assets; (6) a material increase in cllateral required t be maintained at registered clearing agencies f which it is a member; and (7) the ptential fr a material lss f liquidity caused by market participants exercising cntractual rights and/r refusing t enter int transactins with respect t the varius businesses, psitins, and cmmitments f the SD. 11

12 Nnbank SDs and MSPs Financial Recrds. The Prpsed Rule wuld require a nnbank SD r MSP t keep current ledgers summarizing each transactin affecting its asset, liability, incme, expense and capital accunts. CFTC Reprts and Ntificatins. A nnbank SD r MSP wuld be required t file the fllwing reprts with the CFTC: 19 Frequency Weekly Mnthly Quarterly Annually Type f Reprt All pen uncleared swap psitins, srted by cunterparty and asset class Fr each cunterparty with which the SD r MSP has an pen uncleared swap psitin, the ttal initial margin psted by the SD r MSP, the ttal initial margin cllected by the SD r MSP, and the net variatin margin paid r cllected by the SD r MSP ver the previus week Unaudited financial reprts Summary infrmatin regarding the SD s r MSP s psitins and cunterparty expsures Infrmatin abut the SD s r MSP s hldings and pstings f margin, including infrmatin abut third-party custdians If the SD has apprval t use internal market r credit risk mdels, additinal infrmatin regarding the SD s risks, expsures, and Liquidity Stress Test results If the SD has apprval t use internal market r credit risk mdels, infrmatin regarding daily trading lsses in excess f daily VaR and backtesting infrmatin Audited financial reprts In certain instances, a nnbank SD r MSP dually registered as an FCM with the CFTC r as an SBSD with the SEC culd instead submit reprts prepared in accrdance with FCM r SBSD financial reprting rules. In additin, a nnbank SD r MSP wuld be required t prvide ntice t the CFTC upn the ccurrence f specified events, including nncmpliance with capital and liquidity requirements and nncmpliance with margin requirements abve certain threshlds. Public Disclsures. A nnbank SD r MSP wuld be required t make publicly available n its website: (i) at least quarterly, a statement f the SD s r MSP s financial cnditin, its regulatry capital as f the end f the quarter, and the amunt f its minimum regulatry capital requirement; and (ii) at least annually, a statement f financial cnditin frm the SD s r MSP s audited financial statements and a statement disclsing the SD s r MSP s minimum regulatry capital. Use f U.S. GAAP. A nnbank SD r MSP wuld generally be required t prepare its ledgers and financial reprts in accrdance with U.S. GAAP, except that a Nn-U.S. SD r MSP wuld be allwed t prepare these ledgers and statements in accrdance with Internatinal Financial Reprting Standards ( IFRS ) if it des nt therwise prepare statements under U.S. GAAP. A Nn-U.S. SD r MSP wuld nt be eligible t use IFRS if it prepares U.S. GAAP financial statements as part f cnslidatin int a U.S. parent cmpany. Bank SDs and MSPs Bank SDs and MSPs wuld be required t file the fllwing reprts with the CFTC: In additin t the requirements belw, the CFTC may, by written ntice, require a nnbank SD r MSP t file financial infrmatin n a daily basis r at such ther times as may be specified by the CFTC. 20 In additin t the requirements belw, the Cmmissin may, by written ntice, require a bank SD r MSP t file financial infrmatin n a daily basis r at such ther times as may be specified by the CFTC. 12

13 Frequency Weekly Quarterly Type f Reprt All pen uncleared swap psitins, srted by cunterparty and asset class Fr each cunterparty with which the SD r MSP has an pen uncleared swap psitin, the ttal initial margin psted by the SD r MSP, the ttal initial margin cllected by the SD r MSP, and the net variatin margin paid r cllected by the SD r MSP ver the previus week Financial reprts and psitin infrmatin A bank SD r MSP wuld als be required t prvide ntice t the CFTC upn the ccurrence f specified events, including nncmpliance with capital requirements r nncmpliance with margin requirements abve certain threshlds. Public Disclsures. A bank SD r MSB wuld be required t make publicly available n its website at least quarterly a statement f the SD s r MSP s financial cnditin and a statement disclsing the amunt f the SD s r MSP s regulatry capital as f the end f the quarter and the amunt f its minimum regulatry capital requirement. Substituted Cmpliance. In what might be an versight, a bank SD r MSP rganized and dmiciled utside the United States wuld nt appear t be eligible fr the substituted cmpliance regime described belw in cnnectin with the financial reprting requirements described abve. The CFTC wuld issue cmparability determinatins n a jurisdictin-by-jurisdictin basis, based n cnsideratin f: (i) the scpe and bjectives f a nn-u.s. jurisdictin s capital requirements; (ii) hw such capital requirements cmpare t the internatinal Basel capital standards; (iii) whether a nn-u.s. jurisdictin s capital adequacy and financial reprting requirements achieve cmparable utcmes t the CFTC s crrespnding requirements; (iv) the ability f the relevant nn-u.s. regulatry authrity t supervise and enfrce cmpliance; and (v) any ther facts r circumstances the CFTC deems relevant. If the CFTC has made a cmparability determinatin fr a Nn-U.S. SD s r MSP s hme cuntry jurisdictin, the Nn-U.S. SD r MSP wuld be required t file a ntice f its intent t cmply with its hme cuntry capital adequacy and financial reprting requirements with the NFA. Befre it culd rely n substituted cmpliance, the Nn-U.S. SD r MSP wuld be required t btain a cnfirmatin frm the NFA. This final step is an additinal administrative requirement nt currently required fr ther CFTC rules, and it is nt clear what additinal infrmatin the NFA might require a Nn-U.S. SD r MSP t submit. CLEARY GOTTLIEB SUBSTITUTED COMPLIANCE The Prpsed Rule wuld permit a Nn-U.S. SD r MSP t cmply with the Prpsed Rule by substituting cmpliance with the crllary requirements f its hme cuntry jurisdictin. Substituted cmpliance wuld nly be available if the CFTC issues a determinatin that the Nn-U.S. SD s r MSP s hme cuntry requirements are cmparable t the CFTC s. The Prpsed Rule wuld establish a prcess pursuant t which a Nn-U.S. SD r MSP r its hme-cuntry regulatr culd apply t the CFTC fr such a determinatin by submitting dcumentatin and infrmatin abut the nn-u.s. requirements. 13