CFTC Proposes to Streamline Uncleared Swap Segregation Rules

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Walter Moore
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1 CFTC Prpses t Streamline Uncleared Swap Segregatin Rules August 6, 2018 On July 24, 2018, the Cmmdity Futures Trading Cmmissin (the CFTC ) unanimusly apprved a Ntice f Prpsed Rulemaking (the Prpsal ) 1 t amend its regulatins gverning the right f cunterparties t elect segregatin f initial margin psted t swap dealers ( SDs ) and majr swap participants ( MSPs ) in cnnectin with uncleared swap transactins (the IM Seg Rules ). 2 The Prpsal respnds t cncerns regarding the high degree f cmplexity in administering the IM Seg Rules, which ges beynd what is required by the Cmmdity Exchange Act If yu have any questins cncerning this memrandum, please reach ut t yur regular firm cntact r the fllwing authrs New Yrk Clin D. Llyd cllyd@cgsh.cm Brian J. Mrris bmrris@cgsh.cm ( CEA ) and places significant burdens n SDs, MSPs and their cunterparties, despite the fact that a very small minrity f cunterparties have elected t segregate margin pursuant t the IM Seg Rules. 3 Accrdingly, the Prpsal is designed t align the requirements f the IM Seg Rules mre clsely with the statutry text. This Memrandum prvides an verview f the Prpsal. Included as Appendix A t this Memrandum is a cmparisn shwing changes that wuld be implemented by the Prpsal t the text f the current IM Seg Rules. Cmments n the Prpsal are due by September 28, Segregatin f Assets Held as Cllateral in Uncleared Swap Transactins, 83 Fed. Reg (July 30, 2018). 2 CFTC Regulatins, Subpart L; 17 C.F.R ; Prtectin f Cllateral f Cunterparties t Uncleared Swaps; Treatment f Securities in a Prtfli Margining Accunt in a Cmmdity Brker Bankruptcy, 78 Fed. Reg (Nv. 6, 2013). 3 In his cncurring statement n the Prpsal, hwever, CFTC Cmmissiner Rstin Benham suggested that perhaps impsing mre rigid segregatin requirements n SDs and MSPs wuld increase incentives fr cunterparties t elect segregatin. 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 Backgrund In 2010, the Ddd-Frank Act amended the CEA t add Sectin 4s(l), which prvides a cunterparty with the right t elect segregatin f initial margin psted t an SD r MSP fr uncleared swap transactins. 4 Sectin 4s(l) als includes related ntificatin and reprting requirements. 5 In 2013, the CFTC implemented these requirements when it finalized the IM Seg Rules. As nted belw, the IM Seg Rules went well beynd the CEA t impse additinal cnditins n required segregatin ntices and accunt requirements. The IM Seg Rules became effective n May 5, 2014 fr new cunterparties and Nvember 3, 2014 fr existing cunterparties. In Octber 2014, the CFTC issued an interpretive letter ( Letter ), 6 which prvided guidance reducing sme f the cmplexity and ambiguity assciated with the IM Seg Rules, but still retained mst f the IM Seg Rules extra-statutry requirements. The CFTC and Prudential Regulatrs 7 subsequently finalized uncleared swaps margin rules ( Mandatry Margin Rules ), 8 which require a minimum amunt f initial margin t be exchanged with, and segregated by, certain cunterparties. 9 As part f the Mandatry Margin Rules, the CFTC clarified that the IM Seg Rules d nt apply t initial margin cvered by its versin f the Mandatry Margin Rules, but it did nt address the Prudential Regulatrs parallel rules. In 2017, the CFTC initiated Prject KISS, pursuant t which it requested and received public cmment n streamlining the CFTC s regulatins, 10 including cmments suggesting that the CFTC simplify sme f the mre burdensme and prescriptive aspects f the IM Seg Rules. The CFTC Prpsal Ntificatin Requirements The Prpsal wuld amend the ntice prvisins f the IM Seg Rules by eliminating extra-statutry requirements t: prvide annual re-ntificatin f the right t elect segregatin; include specified infrmatin regarding eligible third-party custdians and the csts f segregatin; prvide ntificatin t a specified fficer f the cunterparty; 11 and 4 CEA 4s(l); 7 U.S.C. 6s(l). 5 Id. 6 CFTC Letter N (Oct. 31, 2014). 7 The Prudential Regulatrs include the Federal Reserve Bard, the Office f the Cmptrller f the Currency, the Federal Depsit Insurance Crpratin, the Farm Credit Administratin and the Federal Husing Finance Agency. 8 Margin Requirements fr Uncleared Swaps fr Swap Dealers and Majr Swap Participants, 81 Fed. Reg. 636 (Jan. 6, 2016); Margin and Capital Requirements fr Cvered Swap Entities, 80 Fed. Reg. (Nv. 30, 2015). 9 See CGSH Alert Memrandum, Agencies Finalize Margin Rules fr Nn-Cleared Swaps and Security-Based Swaps (Jan. 28, 2016), available at 10 See Prject KISS, 82 Fed. Reg (May 24, 2017); Prject KISS, 82 FR (May 6, 2017). 11 The CFTC indicated in the Prpsal that it expects SDs and MSPs t use reasnable judgment t identify an 2

3 btain cnfirmatin frm the cunterparty f bth its receipt f the ntificatin and its decisin whether t elect segregatin. Under the Prpsal, the bligatins f the SD r MSP with respect t cunterparty ntificatin wuld thus be limited t: prviding a single ntificatin f the cunterparty s right t elect segregatin f initial margin at the beginning f the first swap transactin that prvides fr the exchange f initial margin; 12 and fr cunterparties electing segregatin, btaining written cnfirmatin f such electin and establishing the terms f such segregatin by written agreement. As under the current IM Seg Rules, the Prpsal wuld permit a cunterparty t change its electin whether r nt t segregate at its discretin by written ntice t the SD r MSP. The Prpsal s amendments wuld supersede interpretive relief in Letter that had permitted reliance n negative cnsent nt t segregate because, as amended, the IM Seg Rules wuld n lnger require an SD r MSP t btain cnfirmatin f an electin nt t segregate. Like Letter , the Prpsal wuld clarify that the IM Seg Rules nly apply t cunterparties that pst initial margin. In additin, the Prpsal wuld clarify that the right t segregatin under the IM Seg Rules, and the assciated ntificatin requirement, wuld nt apply t margin segregated pursuant t the Prudential Regulatrs Mandatry Margin Rules, in additin t the CFTC s Mandatry Margin Rules. Requirements fr Custdy f Segregated Initial Margin The Prpsal wuld retain the requirements that (1) a custdian f initial margin be a legal entity independent f bth the SD r MSP and the cunterparty (althugh such entity may be affiliated with the SD, MSP r cunterparty) and (2) the initial margin be held in an accunt segregated fr, and n behalf f, the cunterparty, and designated as such. This accunt naming requirement cntinues t raise questins regarding custmary segregatin arrangements fr initial margin, in which the custdial accunt is typically held in the name f the pledgr fr the benefit f the secured party. The Prpsal wuld als retain the requirement that the parties enter int a written segregatin agreement that requires, at a minimum, written instructin and ntificatin f any withdrawals f initial margin. Hwever, the Prpsal wuld eliminate the requirement fr withdrawals f margin t be accmpanied by a statement t the custdian that is, swrn, written, subject t penalty f perjury, and states that the relevant party is entitled t assume cntrl f the initial margin. Investment f Segregated Initial Margin The Prpsal wuld cntinue t permit parties t enter int cntractual arrangements requiring the investment f segregated margin apprpriate persn at the cunterparty wh can evaluate the right t elect segregatin. sufficient fr purpses f cmplying with the IM Seg Rules as amended by the Prpsal. Prpsal at n The CFTC nted in the Prpsal that segregatin ntices sent under the current IM Seg Rules wuld be 3

4 and related allcatin f investment gains and lsses. Hwever, the Prpsal wuld remve the requirement that segregated initial margin be invested in a manner cnsistent with CFTC Regulatin CFTC Regulatin 1.25 is intended t prtect clients trading in exchange-traded futures and cleared swaps, which are subject t standardized terms, including with respect t the investment f segregated initial margin; in cntrast, in the cntext f uncleared swaps, parties regularly negtiate bespke transactins and are able t negtiate cntractual prtectins and t agree n investment decisins fr segregated initial margin in that cntext. 13 Additinally, because investment decisins fr segregated margin fr uncleared swaps are typically made by the cunterparty and/r custdian nt the SD r MSP applying CFTC Regulatin 1.25 in this cntext wuld be detrimental t the cunterparty s interests by restricting its investment discretin. Nr are such restrictins necessary t prtect the SD r MSP since, by definitin, the IM Seg Rules apply t margin the SD r MSP is nt required t cllect in the first place. Reprting Requirements fr Nn-Segregated Initial Margin The Prpsal wuld, hwever, streamline implementatin f this requirement by: eliminating the bligatin f the chief cmpliance fficer ( CCO ) f the SD r MSP t be the individual wh prvides the quarterly reprt, since the CCO might nt be the best-placed individual t d s; 14 clarifying the timing f delivery f the reprt (n later than 15 business days after the end f the relevant quarter); and eliminating the requirement that the reprt indicate whether r nt the back ffice prcedures were nt in cmpliance with the agreement f the parties at any pint during the previus calendar quarter. Althugh the CFTC did nt prvide guidance as t the cntent f the quarterly reprting bligatin, SDs and MSPs have established practices in this area that we wuld expect t cntinue fllwing adptin f the Prpsal. CLEARY GOTTLIEB The Prpsal wuld retain rules addressing the statutry requirement fr SDs and MSPs t reprt quarterly t cunterparties nt electing segregatin f initial margin whether the back ffice prcedures f the SD r MSP relating t margin and cllateral requirements are in cmpliance with the agreement f the parties. 13 The Prpsal des acknwledge that, in sme situatins, nnfinancial end-user cunterparties may have less negtiating pwer with SDs r MSPs as a result f this Prpsal, and the Prpsal slicits cmments n these issues, including whether cunterparties are at a disadvantage in negtiating the terms fr segregatin arrangements mre generally. Prpsal at The Prpsal des nte, hwever, that the CCO wuld remain respnsible, under CFTC Regulatin 3.3, fr addressing nn-cmpliance issues, including issues related t these prcedures. 4

5 APPENDIX A Subpart L Segregatin f Assets Held as Cllateral in Uncleared Swap Transactins Definitins. As used in this subpart: Initial Margin means mney, securities, r prperty psted by a party t a swap as perfrmance bnd t cver ptential future expsures arising frm changes in the market value f the psitin. Margin means bth Initial Margin and Variatin Margin. Segregate. T segregate means t keep tw r mre items is t keep them in separate accunts, and t avid cmbining them in the same transfer between tw accunts. Variatin Margin means a payment made by r cllateral psted by a party t a swap t cver the current expsure arising frm changes in the market value f the psitin since the trade was executed r the previus time the psitin was marked t market Ntificatin f right t segregatin. (a) Prir t the executin f eachat the beginning f the first swap transactin that is nt submitted fr clearingprvides fr the exchange f Initial Margin, a swap dealer r majr swap participant shall:must ntify the cunterparty that (1) Ntify each cunterparty t such transactin that the cunterparty has the right t require that any Initial Margin the cunterparty prvides in cnnectin with such transactin be segregated in accrdance with and , except in thse circumstances where segregatin is mandatry pursuant t ; r rules adpted by the prudential regulatrs pursuant t sectin 4s(e)(2)(A) f the Act. (2) Identify ne r mre custdians, ne f which must be a creditwrthy nn-affiliate and each f which must be a legal entity independent f bth the swap dealer r majr swap participant and the cunterparty, as an acceptable depsitry fr segregated Initial Margin; and (3) Prvide infrmatin regarding the price f segregatin fr each custdian identified in paragraph (a)(2) f this sectin, t the extent that the swap dealer r majr swap participant has such infrmatin. (b) The right referred t in paragraph (a) f this sectin des nt extend t Variatin Margin. (c) If the cunterparty elects t segregate Initial Margin, the terms f segregatin shall be established by written agreement.the ntificatin referred t in paragraph (a) f this sectin shall be made t an fficer f the cunterparty respnsible fr the management f cllateral. If n such party is identified by the cunterparty t the swap dealer r majr swap participant, then the ntificatin shall be made t the Chief Risk Officer f the cunterparty, r, if there is n such Officer, the Chief Executive Officer, r if nne, the highest-level decisinmaker fr the cunterparty. (d) Prir t cnfirming the terms f any such swap, the swap dealer r majr swap participant shall btain frm the cunterparty cnfirmatin f receipt by the persn specified in paragraph (c) f this sectin f the ntificatin specified in paragraph (a) f this sectin, and an electin, if applicable, t require such segregatin r nt. The swap dealer r majr swap participant shall maintain such cnfirmatin and such electin as business recrds pursuant t 1.31 f this chapter. 5

6 (e) Ntificatin pursuant t paragraph (a) f this sectin t a particular cunterparty by a particular swap dealer r majr swap participant need nly be made nce in any calendar year. (fd) A cunterparty s electin, if applicable, t require segregatin f Initial Margin r nt t require such segregatin, may be changed at the discretin f the cunterparty upn written ntice delivered t the swap dealer r majr swap participant, which changed electin shall be applicable t all swaps entered int between the parties after such delivery Requirements fr segregated initial margin. (a) The custdian f Initial Margin, segregated pursuant t an electin under , must be a legal entity independent f bth the swap dealer r majr swap participant and the cunterparty. (b) Initial Margin that is segregated pursuant t an electin under must be held in an accunt segregated fr, and n behalf f, the cunterparty, and designated as such. Such an accunt may, if the swap dealer r majr swap participant and the cunterparty agree, als hld Variatin Margin. (c) Any agreement fr the segregatin f Initial Margin pursuant t this sectin shall be in writing, shall include the custdian as a party, and shall prvide that: any instructin t withdraw Initial Margin shall be in writing and that (1) Any withdrawal f such Margin, ther than pursuant t paragraph (c)(2) f this sectin, shall nly be made pursuant t the agreement f bth the cunterparty and the swap dealer r majr swap participant, and ntificatin f suchthe withdrawal shall be given immediately t the nn-withdrawing party;. (2) Turnver f cntrl f such Margin shall be made withut the written cnsent f bth parties, as apprpriate, t the cunterparty r t the swap dealer r majr swap participant, prmptly upn presentatin t the custdian f a statement in writing, made under ath r under penalty f perjury as specified in 28 U.S.C. 1746, by an authrized representative f either such party, stating that such party is entitled t such cntrl pursuant t an agreement between the parties. The ther party shall be immediately ntified f such turnver Investment f segregated initial margin. (a) Margin that is segregated pursuant t an electin under may nly be invested cnsistent with 1.25 f this chapter. (b) Subject t paragraph (a) f this sectin, thethe swap dealer r majr swap participant and the cunterparty may enter int any cmmercial arrangement, in writing, regarding the investment f suchinitial Margin, segregated pursuant t and the related allcatin f gains and lsses resulting frm such investment Requirements fr nn-segregated margin. (a) The chief cmpliance fficer f eeach swap dealer r majr swap participant shall reprt t each cunterparty that des nt chse t require segregatin f Initial Margin pursuant t (a), n a quarterly basis, n later than the fifteenth business day f each calendarafter the end f the quarter, n whether r ntthat the back ffice prcedures f the swap dealer r majr swap participant relating t margin and cllateral requirements were, at any pint during the previus calendar quarter, ntare in cmpliance with the agreement f the cunterparties. (b) The bligatin specified in paragraph (a) f this sectin shall apply with respect t each cunterparty n earlier than the 90th calendar day after the date n which the first swap is transacted between the cunterparty and the swap dealer r majr swap participant. 6

Clearing arrangements

Clearing arrangements Rules Ntice Guidance Nte Dealer Member Rules Please distribute internally t: Internal Audit Legal and Cmpliance Operatins Regulatry Accunting Senir Management Cntact: Richard J. Crner Vice President, Member