The proposed margin rules from the CFTC and the prudential regulators, when considered alongside the existing CFTC collateral segregation rules, present the potential for three different collateral segregation regimes applying to initial margin posted to a swap dealer. To compare the differences, we have created a chart of the three collateral segregation regimes, available here.
The Dodd-Frank Act provided the customers of swap dealers the “right” to require segregation of initial margin for uncleared swaps, instead of posting such margin directly with the swap dealer. In November of 2013, the CFTC released the final rules implementing collateral segregation for initial margin on uncleared swaps (the “CFTC Collateral Segregation Rules”). See our prior post for a Q&A on the CFTC Collateral Segregation Rules.
Separately, both the CFTC and the prudential regulators have now proposed rules requiring swap dealers and certain financial end-user counterparties to post collateral as margin for uncleared swaps (the “CFTC Margin Rules” and the “Bank Margin Rules”, respectively, and together the “Margin Rules”). The Bank Margin Rules would apply to uncleared swaps with prudentially regulated swap dealers and the CFTC Margin Rules would apply to uncleared swaps with all other swap dealers. The Margin Rules propose requirements for swap dealers to segregate initial margin posted by counterparties.
The CFTC Collateral Segregation Rules, CFTC Margin Rules, and Bank Margin Rules, however, each set out somewhat different regimes with respect to the requirements for collateral segregation for initial margin posted to a swap dealer, and each set of rules applies to a different group of swap dealers. Click here for a chart identifying the differences between the collateral segregation regimes.
Overall, the CFTC Collateral Segregation Rules provide for more detailed segregation requirements and are (in some respects) more protective of the counterparty. For example, the CFTC Collateral Segregation Rules require the account to be held for and on behalf of the counterparty and typically provide for joint control of the collateral. Importantly, however, the CFTC Collateral Segregation Rules would allow an affiliate of the swap dealer to be the custodian if it is a separate legal entity where the Margin Rules prohibit swap dealer affiliates from being a custodian.
The CFTC Margin Rules also propose to exclude margin required to be posted by the counterparty under the CFTC Margin Rules from the counterparty’s ability to elect segregation under the CFTC Collateral Segregation Rules. There is no such exclusion for initial margin required by the Bank Margin Rules. More importantly, the CFTC Margin Rules propose to reduce the segregation protections available to counterparties for collateral required to be posted to non-prudentially regulated swap dealers, but without indicating how these rules can be rationalized with the CFTC Collateral Segregation Rules.
It may not be necessary for all three rules to use the same collateral segregation regime, but the rules really should work together, or non-swap dealer counterparties will be unclear as which protections that the law intends them to have. The CFTC Collateral Segregation Rules apply at the election of the counterparty. The Margin Rules could provide for the a basic level of segregation and the CFTC Collateral Segregation Rules would then provide the counterparty the option to elect a more protective regime. As proposed, however, the segregation regimes are inconsistent, and the CFTC Collateral Segregation Rules apply differently depending on whether the collateral is required by the CFTC Margin Rules.
As an aside and final note: Historically parties have not voluntarily segregated collateral for swaps unless required by some other regulation (such as the Investment Company Act of 1940). To date, most counterparties have opted not to require segregation of collateral under the CFTC Collateral Segregation Rules. This is primarily because of the following additional costs—
- Custodian fees; and
- The swap dealer’s increase in the swap pricing due to losing the income that it would earn from investing the collateral.
If initial margin is required to be segregated under the Margin Rules, those segregation costs (at least for initial margin) will no longer be additional; custodian fees and the lost ability to invest collateral will already apply. As a result, we expect that more counterparties will be willing to elect the protections under the CFTC Collateral Segregation Rules once the Margin Rules come into effect. But The Swap Report believes the collateral segregation regime imposed by the Dodd-Frank Act rules on swap dealers of all types should be consistent, in any event.
Comments on the Bank Margin Rules are due November 24, 2014 and comments on the CFTC Margin Rules are due December 2, 2014. The Swap Report