Certain margin requirements are due to be implemented by 1 September 2017. Dr Sharon Brown-Hruska, PRIME Finance Expert and former Chairman and Commissioner, Commodity Futures Trading Commission (CFTC) discusses the implementation of these margin requirements and how the market has prepared itself to comply with them.
What are the margin requirements that are set to be implemented by September 2017?
United States Prudential Regulators and the United States CFTC published final rules in the Federal Register regarding initial and variation margin requirements applicable to uncleared swap and security-based swap transactions in late 2015 (see 80 FR 74839, 30 November 2015) and early 2016 (see 81 FR 635, 6 January 2016) respectively.
These rules called for the gradual implementation of initial margin requirements, with swap entities with more than $3tn in swaps notional value required to post or collect initial margin in connection with new transactions with covered swap entities and financial end-users with material swaps exposure as of 1 September 2016. The threshold falls to $2.25tn in notional value on 1 September 2017, falls to $1.5tn on 1 September 2018, falls to $750bn on 1 September 2019, and falls to $8bn on 1 September 2020.
Swap entities with notional values greater than $3tn were subject to variation margin requirements with all uncleared swap counter-parties that were either swap entities or financial end-users as of 1 September 2016. All other swap entities were required to comply with variation margin requirements as of 1 March 2017.
However, the CFTC published a no-action letter, CFTC Letter No. 17-11 on 13 February 2017, that granted no-action relief on variation margin requirements until 1 September 2017, provided that a swap entity was not complying with variation margin requirements ‘solely because [the swap entity] has not, despite good faith efforts, completed necessary credit support documentation (including custodial segregation documentation, if any)’ or the swap entity ‘requires additional time to implement operational processes to settle variation margin in accordance’ with regulatory requirements.
Why were these requirements pushed back from the original March 2017 deadline?
The CFTC received requests for relief from many swap entities and financial industry groups, who noted that swap entities are required to ‘execute new or amended credit support documentation with virtually all swap end-users, as well as put in place new operational processes to settle variation margin in accordance with regulations’ (see CFTC letter No 17–11, 13 February 2017). This process, often called ‘repapering,’ is time-consuming and costly.
In a letter to regulators (the ISDA Letter), ISDA and other industry groups warned that of more than 159,000 credit support annexes that were estimated to need to be amended, replaced, or executed, only a tiny fraction had been executed by 27 January 2017. The ISDA Letter also warned that there could be market disruptions if some firms were unable to access the swaps market due to the slow pace of executions of compliant credit support annexes and other documentation.
How has the market prepared itself in the past 6 months to comply with the new deadline?
By all accounts, firms have been rushing to complete most of their ‘repapering’ by 1 September 2017. According to ISDA’s blog, swap entities have made enormous progress thanks to the extra six months that no-action relief provided them:
with the forbearance set to expire in certain jurisdictions, including the US, on 1 September, the industry is in a much better position than it was earlier this year. At the end of February, the estimated proportion of required CSA amendments that had been completed stood at one third. That had reached 90% by the week ending 11 August. The 60-odd percentage-point increase represents tens of thousands of newly amended CSAs, each requiring hours and hours of complex bilateral negotiations with counterparties to agree the changes
What happens if a market participant is not ready to comply with the requirements by 1 September?
If firms would be required to exchange variation margin under regulations for swaps for which they are counterparties, but the firms have not executed credit support documents that would allow them to comply with regulatory requirements, then they would be unable to transact with one another until the relevant credit support documents have been executed. This creates the potential for market fragmentation: if a firm has executed relevant credit support documents with one set of dealers but not another, then it can only transact with the subset of dealers with which it has compliant documentation. For some entities that have been slow in executing the required documentation, it is possible they could be unable to access the uncleared over-the-counter derivatives market to the extent required to manage their risks until the required documents are executed.
Concerns are larger for smaller entities and those with smaller positions, like many buy-side entities, since swap entities have generally prioritized their larger counterparties in the repapering process.
What is the next deadline that market participants need to look to start complying with in relation to margin?
The next deadline depends on the jurisdiction of a particular swap entity. In the United States, the initial margin threshold falls again on 1 September 2018, to $1.5tn in notional value. In other jurisdictions, there are other deadlines in between. For example, ISDA has noted that ‘the European Union (EU) will bring physically settled FX forwards into scope of the non-cleared margin rules from 3 January—the only jurisdiction to do so—which will result in another wave of CSA negotiations’ for swap entities transacting in the EU and/or with EU counterparties.
Dr Sharon Brown-Hruska would like to thank Trevor Wagener and NERA Economic Consulting for research support.
Interviewed by Emma Millington.
The views expressed by our Legal Analysis interviewees are not necessarily those of the proprietor.