Derivatives Practice Alert
May 2011
Authors:
Anthony R.G. Nolan
anthony.nolan@klgates.com
+1.212.536.4843
Lawrence B. Patent
lawrence.patent@klgates.com
+1.202.778.9219
Lloyd H. Johnson II
lloyd.johnson@klgates.com
+1.212.536.3913
K&L Gates includes lawyers practicing out
of 37 offices located in North America,
Europe, Asia and the Middle East, and
represents numerous GLOBAL 500,
FORTUNE 100, and FTSE 100
corporations, in addition to growth and
middle market companies, entrepreneurs,
capital market participants and public
sector entities. For more information,
visit www.klgates.com.
CFTC and Banking Regulators Issue
Proposed Margin Requirements for Noncleared Swaps under Sections 731 and 764 of
the Dodd-Frank Act
On April 12, 2011, the Office of the Comptroller of the Currency (the “OCC”), the
Board of Governors of the Federal Reserve System (the “Fed”), the Federal Deposit
Insurance Corporation (the “FDIC”), the Farm Credit Administration (the “FCA”)
and the Federal Housing Finance Agency (the “FHFA,” and with the OCC, Fed,
FDIC and FCA, collectively, the “Prudential Regulators”) and the Commodity
Futures Trading Commission (the “CFTC”) issued proposed rules1 regarding margin
requirements for non-cleared swaps (and, in the case of the Prudential Regulators,
security-based swaps) pursuant to the Dodd-Frank Act.
Public comment on the Prudential Regulator Proposed Rules must be submitted on or
before June 24, 2011. Public comment on the CFTC Proposed Rules must be
submitted by June 27, 2011.
Background
Section 731 of the Dodd-Frank Act creates new Section 4s of the Commodity
Exchange Act (the “CEA”), which addresses the registration and regulation of swap
dealers and major swap participants. CEA Section 4s(e) requires swap dealers
(“SDs”) and major swap participants (“MSPs”) that are bank entities within the
jurisdiction of one of the Prudential Regulators to meet the capital requirements and
initial and variation margin requirements that such Prudential Regulator prescribes.
Additionally, non-bank swap dealers and major swap participants are required to
meet minimum capital requirements and initial and variation margin requirements.
Section 764 of the Dodd-Frank Act creates new Section 15F(e) of the Securities
Exchange Act of 1934, which contains requirements identical to those in CEA
Section 4s(e), but for security-based swap dealers (“SB-SDs”) and major securitybased swap participants (“SB-MSPs”).
The intervention of the Prudential Regulators in the regulatory process represents a
complicating factor in the implementation of Title VII of the Dodd-Frank Act
because they previously had not been as involved as the CFTC in addressing the
concerns of end users and other market participants over appropriate margin
arrangements for swaps. This is a particularly important development in light of the
substantive differences, as well as the differences in approach, between the CFTC on
the one hand and the Prudential Regulators on the other.
1
Margin and Capital Requirements for Covered Swap Entities (OCC Docket No. OCC-2011-0008)
(the “Prudential Regulator Proposed Rules”); Margin Requirements for Uncleared Swaps for Swap
Dealers and Major Swap Participants, 76 Fed. Reg. 2372 (April 28, 2011) (the “CFTC Proposed
Rules”).
Derivatives Practice Alert
Margin Requirements on Non-cleared
Swaps and Security-Based Swaps
The Prudential Regulator Proposed Rules and CFTC
Proposed Rules propose margin requirements for
certain covered swap entities and, in the case of the
Prudential Regulator Proposed Rules, security-based
swap entities. Prudential Regulators consider
covered swap entities to be SDs, MSPs, SB-SDs and
SB-MSPs that they currently regulate (“Prudential
CSEs”). The CFTC considers CSEs to be SDs or
MSPs for which there is no prudential regulator
(“CFTC CSEs”).
Both the Prudential Regulator Proposed Rules and
the CFTC Proposed Rules would impose margin
requirements that are risk-based in nature.
Specifically, the Prudential Regulator Proposed
Rules have separate margin requirements for
Prudential CSEs with respect to positions between
such Prudential CSE and (1) other Prudential CSEs,
(2) counterparties that are “high-risk financial end
users”2 of derivatives, (3) counterparties that are
“low-risk financial end users”3 and
(4) counterparties that are “nonfinancial end
2
“High-risk financial end users” are defined in the Prudential
Regulator Proposed Rules as counterparties that are financial
end users, but not low risk financial end users. The Prudential
Regulator Proposed Rules define “financial end users” as any
counterparty that is: (1) a commodity pool as defined in
Section 1a(5) of the CEA; (2) a private fund as defined in
Section 202(a) of the Investment Advisers Act of 1940; (3) an
employee benefit plan as defined in paragraphs (3) and (32) of
Section 3 of the Employee Retirement Income Security Act of
1974; (4) a person predominantly engaged in activities that are
in the business of banking, or in activities that are financial in
nature, as defined in Section 4(k) of the Bank Holding
Company Act of 1956; (5) a commodity pool or private fund
that would be a financial end user, if it were organized under
the laws of the United States or any State thereof; (6) a
government of any foreign country or a political subdivision,
agency, or instrumentality thereof; or (7) any other person the
relevant Prudential Regulator may designate.
3
“Low-risk financial end users” are defined as counterparties
that are financial end users and make the following
representations to a Prudential CSE in connection with
entering into a swap or security-based swap with the
Prudential CSE: (1) the counterparty does not have significant
swaps exposure; (2) the counterparty predominantly uses
swaps or security-based swaps to hedge or mitigate the risks
of its business activities, including balance sheet, interest rate,
or other risk arising from the business of the counterparty; and
(3) the counterparty is subject to capital requirements
established by a Prudential Regulator or state insurance
regulator.
users.” 4 In contrast, the CFTC Proposed Rules have
separate margin requirements for CFTC CSEs with
respect to positions between such CFTC CSE and
(1) other SDs or MSPs (whether or not such SD or
MSP is under the jurisdiction of one of the
Prudential Regulators), (2) “financial entities” and
(3) “non-financial entities.”5
It is important to note that the Prudential Regulator
Proposed Rules would require the Prudential CSEs
to collect, but not post, initial and variation margin.
This could have implications for the obligations of
registered investment companies to maintain
custody of posted margin pursuant to Section 17(a)
of the Investment Company Act. It may also raise
questions about the extent to which tri-party control
arrangements would be in compliance with the
margin requirements of the Prudential Regulator
Proposed Rules. The CFTC Proposed Rules would
not require that CFTC CSEs collect margin from
non-financial entities, but simply would require that
they enter into credit support arrangements with
their counterparties and abide by those
arrangements. Such credit support arrangements
could include unsecured guarantees.
Initial Margin
Prudential Regulator Proposed Rules
Section __.36 of the common Prudential Regulator
Proposed Rules would require Prudential CSEs to
collect initial margin for non-cleared swaps or noncleared security-based swaps in an amount no less
than the greater of: (1) zero; or (2) the initial
margin collection amount for such swap or securitybased swap minus the initial margin threshold
amount for the counterparty (not including any
portion of the initial margin threshold amount being
4
“Nonfinancial end users” are defined as counterparties that
are end users but not financial end users.
5
The CFTC Proposed Rules’ definition of “financial entity”
mirrors the definition of “financial end user” in the Prudential
Regulator Proposed Rules. “Nonfinancial entity” means a
counterparty that is not an SD, MSP or financial entity.
6
The proposing release for the Prudential Regulator
Proposed Rules notes that Sections 731 and 764 of the DoddFrank Act require the Prudential Regulators to adopt rules
jointly for swap entities for their respective jurisdictions.
Blanks were included so that each Prudential Regulator can
adopt the Prudential Regulator Proposed Rules in accordance
with its existing set of regulations.
May 2011
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Derivatives Practice Alert
applied to other swaps or security-based swaps with
the counterparty), as applicable.
The initial margin collection amount would be
determined by the Prudential CSE’s existing initial
margin model. Such initial margin model must
conform to certain requirements set forth in
Section __.8 of the common Prudential Regulator
Proposed Rules, including: pre-approval and
ongoing periodic review by the relevant Prudential
Regulator; certain quantitative requirements; certain
control, oversight and validation mechanisms; and
adequate documentation. Alternatively, if the
Prudential CSE does not have an initial margin
model, such amount would be determined based
upon the standardized minimum margin
requirements described in Appendix A of the
common Prudential Regulator Proposed Rules.
These standardized minimum requirements describe
an acceptable percentage range of the notional
amount of the swap, depending on the asset class
associated with the swap.7
end users with strong credit profiles should be able
to continue their swap activities without posting
margin. However, the Prudential Regulators would
not specify either any particular threshold ceiling
for nonfinancial end users or whether to bifurcate
nonfinancial end users into “low-risk” and “highrisk” categories similar to financial end users. This
could limit the practical utility of the commercial
end user exemption from clearing for some end
users.
Prudential CSEs would be required to comply with
the above initial margin requirements for a period
that commences on or before the date they enter into
a swap or security-based swap and ends on the date
such non-cleared swap or security-based swap is
terminated or expires. Additionally, Prudential
CSEs would not have to collect initial margin from
a particular counterparty unless and until the total
amount of initial margin to be collected from such
counterparty is greater than $100,000.
CFTC Proposed Rules
The initial margin threshold amount would be a
credit exposure limit established by the Prudential
CSE that would “appropriately” take into account
and address counterparty and swap credit risk,
subject to review, monitoring and approval in
accordance with such Prudential CSE’s credit
processes. Notwithstanding these guidelines, such
initial margin threshold amount would be required to
be no greater than (1) zero, if the counterparty is
either a Prudential CSE or high-risk financial end
user; or (2) the lesser of $15 to $45 million and 0.1
to 0.3 percent of the Prudential CSE’s tier 1 capital,
if the counterparty is a low-risk financial end user.8
The Prudential Regulators note that the midpoint of
each such range would be an appropriate initial
margin threshold amount. The Prudential Regulator
Proposed Rules would not impose a threshold
ceiling for transactions with nonfinancial end users,
and the Prudential Regulators note that nonfinancial
7
The creditworthiness of the various types of counterparties
was taken into consideration by the Prudential Regulators
when such thresholds were developed.
8
The relevant capital metric for Prudential CSEs regulated by
the FCA and FHFA do not use the tier 1 capital concept, but
rather “total core capital” in the case of the FHFA and
“applicable core surplus or core capital (or successor high
quality capital requirement)” in the case of the FCA.
For non-cleared swaps between CFTC CSEs and
SDs or MSPs, proposed Regulation 23.152 would
require the counterparty to post and maintain the
entire initial margin equal or greater than an amount
calculated pursuant to the CFTC Proposed Rules
with a third party independent custodian until the
swap is liquidated, unless such amount is less than
$100,000. If the credit support arrangements with
the counterparty require an amount greater than the
amount calculated pursuant to the CFTC Proposed
Rules, the counterparty must post and maintain such
amount.
With respect to non-cleared swaps between CFTC
CSEs and financial entities, proposed Regulation
23.153 would require the financial entity
counterparty to post and maintain the entire initial
margin equal in the manner described above. The
initial margin threshold would be the lesser of $15
to $45 million or 0.1 to 0.3 percent of the CFTC
CSE’s regulatory capital.
For non-cleared swaps between CFTC CSEs and
non-financial entities, the CFTC CSE and nonfinancial entity would be required to post and
maintain any initial margin required pursuant to
their credit support arrangement until the swap is
May 2011
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Derivatives Practice Alert
liquidated. That credit support arrangement may
provide for a threshold below which the CFTC CSE
or non-financial entity is required to post initial
margin. The CFTC CSE would additionally have to
calculate a hypothetical initial margin for each noncleared swap on a daily basis as if such counterparty
were an SD and compare such amount to any initial
margin required under the credit support
arrangements.
Initial margin would be calculated using the
methodology contained in the credit support
arrangements with the counterparty, provided that
the model meets the standards set forth in proposed
Regulation 23.155(b), or an alternative method set
forth in proposed Regulation 23.155(c). The
primary risk-based model would have to be
approved by the CFTC and either be currently in use
by a derivatives clearing organization or an entity
subject to regular assessment by a Prudential
Regulator for margining non-cleared swaps. Such
primary model would further require the calculation
model to conform to certain standards, including:
certain theoretical and quantitative requirements;
certain control, oversight and validation
mechanisms; and adequate documentation. The
alternative method of initial margin calculation
would involve the CFTC CSE identifying in credit
support arrangements of swaps cleared by
derivatives clearing organizations in the same asset
class those terms and conditions that “most closely
approximate” the terms and conditions of the noncleared swap.9 The CFTC CSE would then calculate
the number of units of the cleared swap that would
equal the size of the non-cleared swap, determine the
margin the derivatives clearing organization applied
to such analogous position of cleared swaps, and
multiply such amount of margin either (i) by 2.0 for
a cleared swap or (ii) by 4.4 for a cleared futures
contract to determine the margin required for the
non-cleared swap. Reductions to margin could be
made based on offsetting risk characteristics for
currency and interest rate asset classes only. In no
event could such reduction be more than 50% of the
9
If no such cleared swap has similar terms and conditions, the
CFTC CSE would be permitted to look to the terms and
conditions in the credit support arrangements of futures
contracts cleared by such derivatives clearing organization in
the same asset class as the uncleared swap and would most
likely be used to hedge such uncleared swap.
amount required for the non-cleared swap in the
absence of a reduction. CFTC CSEs would be
required to monitor margin levels and collect
additional margin if appropriate to contain risk.10
Initial margin would only be in the form specified in
the credit support arrangements with the
counterparty. If the counterparty is an SD, MSP or
financial entity, the CFTC CSE could post and
accept only the following assets: (1) immediately
available cash in the form of US dollars or the
swap’s required settlement currency; (2) any direct
obligation of or obligation fully guaranteed as to
principal and interest by the United States; and
(3) senior debt obligations of the Federal National
Mortgage Association, Federal Home Loan
Mortgage Corporation, Federal Home Loan Banks
and the Federal Agricultural Mortgage Corporation,
as well as any obligation that is an “insured
obligation” of a Farm Credit System bank. If the
counterparty is a non-financial entity, the CFTC
CSE could accept only assets for which the value is
“reasonably ascertainable” on a periodic basis as
described in the parties’ credit support
arrangements.
Variation Margin
Prudential Regulator Proposed Rules
On and after the date a Prudential CSE enters into a
non-cleared swap or non-cleared security-based
swap, Section __.4 of the common Prudential
Regulator Proposed Rules would require Prudential
CSEs to collect variation margin (to the extent the
variation margin is positive) for non-cleared swaps
or security-based swaps in an amount that is no less
than the greater of: (1) zero; or (2) the variation
margin amount for such swap or security-based
swap minus the initial margin threshold amount for
the counterparty (not including any portion of the
variation margin threshold amount being applied to
other swaps or security-based swaps with the
counterparty), as applicable.
The variation margin amount would be the
cumulative mark-to-market change in value to a
10
It should also be noted that the CFTC could require the
CFTC CSE to post or collect additional margin because of
additional risk posed by a particular product or party to the
uncleared swap.
May 2011
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Derivatives Practice Alert
Prudential CSE of a swap or security-based swap,
and would be measured from the date such swap is
entered into (or the positive or negative value of
such swap on the date such swap is entered into plus
any cumulative mark-to-market change in value to
such Prudential CSE of such swap after such date)
minus the value of all variation margin previously
collected but not returned by the Prudential CSE
(expressed as a positive amount) with respect to
such swap or security-based swap.
provide the variation margin and the Prudential
CSE: (1) has made the “necessary efforts” to
collect the required variation margin, including
timely initiation and continued pursuit of formal
dispute resolution mechanisms, or has made
appropriate efforts to collect to the satisfaction of
the relevant Prudential Regulator; or
(2) commenced termination of the swap or securitybased swap with the counterparty.
CFTC Proposed Rules
The variation margin threshold amount would be a
credit exposure limit established by the Prudential
CSE that would “appropriately” take into account
and address counterparty and swap credit risk
subject to review, monitoring and approval in
accordance with such Prudential CSE’s credit
processes. Notwithstanding these guidelines, such
variation margin threshold amount would be
required to be no greater than (1) zero, if the
counterparty is either a Prudential CSE or high-risk
financial end user; or (2) the lesser of $15 to $45
million and 0.1 to 0.3 percent of the Prudential
CSE’s tier 1 capital, if the counterparty is a low-risk
financial end user. The Prudential Regulators note
that the midpoint of each such range would be an
appropriate initial margin threshold amount.
Prudential CSEs would be required to comply with
the variation margin requirements no less than once
per business day for a counterparty that is a swap
entity or financial end user, and no less than once
per week for a counterparty that is a nonfinancial
end user. Additionally, Prudential CSEs would not
have to collect variation margin from a particular
counterparty unless and until the total amount of
variation margin to be collected from such
counterparty is greater than $100,000.
If the non-cleared swap or security-based swap is
executed pursuant to a qualifying master netting
agreement between a Prudential CSE and its
counterparty, such Prudential CSE could calculate
and comply with the variation margin requirements
above on an aggregate basis as long as the Prudential
CSE complies with the variation margin
requirements for all swaps governed by such master
netting agreement.
It is important to note that Prudential CSEs would
not be required to collect variation margin from a
counterparty if such counterparty refuses or fails to
For non-cleared swaps between CFTC CSEs on the
one hand, and SDs or MSPs on the other, proposed
Regulation 23.152 would require the SD or MSP
counterparty to pay the entire variation margin
equal to or greater than an amount calculated
pursuant to the CFTC Proposed Rules with the
CFTC CSE or a third party independent custodian,
unless such amount is less than the $100,000.
Variation margin would be paid starting the
business day after the swap is executed until
liquidation. The CFTC CSE is permitted to apply
the variation margin requirements to multiple noncleared swaps executed pursuant to swap trading
relationship documentation on an aggregate basis as
long as the CFTC CSE complies with the variation
margin requirements for all such swaps. CFTC
CSEs would not be required to collect variation
margin from a counterparty if such counterparty
refuses or fails to provide the variation margin and
the CFTC CSE: (1) has made the “necessary
efforts” to collect the required variation margin,
including timely initiation and continued pursuit of
formal dispute resolution mechanisms, or has made
appropriate efforts to collect to the satisfaction of
the CFTC; or (2) commenced termination of the
swap or security-based swap with the counterparty.
For non-cleared swaps between CFTC CSEs and
financial entities, proposed Regulation 23.153
would require the counterparty to post and maintain
the entire initial margin calculated in the manner
described above. It is important to note, however,
that the primary difference between the treatment of
SDs and financial entities is that, if a financial entity
is the counterparty, each CFTC CSE would be
required to pay any variation margin required
pursuant to its credit support arrangements between
the CFTC CSE and its counterparty. Such credit
support arrangements could provide for a threshold
May 2011
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Derivatives Practice Alert
below which the CFTC CSE would not be required
to pay variation margin. Further, each CFTC CSE
would be required to calculate each day a
hypothetical variation margin for each non-cleared
swap as if the counterparty were an SD and compare
that amount to any variation margin required
pursuant to the credit support arrangements. The
variation margin threshold would be the lesser of
$15 to $45 million or 0.1 to 0.3 percent of the CFTC
CSE’s regulatory capital.
For non-cleared swaps between CFTC CSEs and
non-financial entities, the CFTC CSE and the nonfinancial entity would be required to post and
maintain any variation margin required pursuant to
their credit support arrangement until the swap is
liquidated. Such credit support arrangement may
provide for a threshold below which the CFTC CSE
or non-financial entity is required to post variation
margin. If the non-cleared swap is executed
pursuant to swap trading relationship documentation
that permits netting, the CFTC CSE could calculate
and comply with the variation margin requirements
above on an aggregate basis as long as the CFTC
CSE complies with the variation margin
requirements for all swaps governed by such
agreement. The CFTC CSE must additionally
calculate a hypothetical variation margin for each
non-cleared swap on a daily basis as if such
counterparty were an SD and compare such amount
to any initial margin required under the credit
support arrangements.
Variation margin is calculated in the manner
specified in the credit support arrangements between
the parties. In addition, the CFTC CSE would be
required to calculate variation margin for itself and
each counterparty that is an SD, MSP or financial
entity. Such calculation must simply be stated with
“sufficient specificity” to allow the counterparty,
CFTC or any applicable Prudential Regulator to
calculate the margin requirement independently.
This calculation is decidedly less onerous than the
standards described in the Prudential Regulator
Proposed Rules. It should be noted, however, that
the CFTC could require the CFTC CSE to provide
further data or analysis about its methodology at any
time.
Variation margin could only be in the form specified
in the credit support arrangements with the
counterparty. If the counterparty is an SD, MSP or
financial entity, a CFTC CSE could only pay and
collect as variation margin cash or United States
Treasury securities. If the counterparty is a nonfinancial entity, the CFTC CSE could accept only
assets for which the value is “reasonably
ascertainable” on a periodic basis as described in the
parties’ credit support arrangements.
Additional Margin Requirements
Prudential Regulator Proposed Rules
Prudential CSEs would be required to execute credit
support arrangement documentation with their
counterparties. Such documentation would provide
the Prudential CSE the contractual right to collect
initial margin and variation margin as required by
the Prudential Regulator Proposed Rules. Such
documentation also would specify: (1) the methods,
procedures, rules and inputs to determine the value
of each swap or security-based swap for variation
margin calculation purposes; and (2) the dispute
resolution procedures for swap valuation or the
valuation of assets collected or posted as initial or
variation margin. Moreover, initial and variation
margin would only be collected from one or more of
the following types of collateral: (1) immediately
available cash in the form of US dollars or the
swap’s required settlement currency; (2) any direct
obligation of or obligation fully guaranteed as to
principal and interest by the United States; and
(3) with respect to initial margin only, senior debt
obligations of the Federal National Mortgage
Association, Federal Home Loan Mortgage
Corporation, Federal Home Loan Banks and the
Federal Agricultural Mortgage Corporation, as well
as any obligation that is an “insured obligation” of a
Farm Credit System bank. The value of the
government obligations considered eligible
collateral for the purposes of the Prudential
Regulator Proposed Rules would be subject to the
discounts described in Appendix B of the common
Prudential Regulator Proposed Rules.
It is important to note that the Prudential CSE
would have to require that all funds or other
property it provides as initial margin would be held
by a third party custodian independent of both the
Prudential CSE and counterparty. Such custodian
would be prohibited from rehypothecating or
otherwise transferring any initial margin it holds.
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Derivatives Practice Alert
Additionally, such custodian would be prohibited
from reinvesting the initial margin in any asset other
than “eligible collateral,” as described in the
Prudential Regulator Proposed Rules. It is also
important to note that the Prudential CSE may
collect initial margin and variation margin that is not
required pursuant to the Prudential Regulator
Proposed Rules in any form of collateral.
Foreign non-cleared swaps or security-based swaps
would not be subject to the margin requirements if
the counterparty is neither an entity organized under
the laws of the United States nor a branch or office
of an entity organized under the laws of the United
States. Margin requirements also would not apply to
persons that are not resident in the United States.11
CFTC Proposed Rules
Proposed Regulation 23.153 provides that CFTC
CSEs could apply thresholds to the initial and
variation margin requirements of counterparties that
are financial entities if such counterparties make the
following representations to the CFTC CSE in
connection with entering into the transaction:
(1) the counterparty is subject to capital
requirements established by a Prudential Regulator
or state insurance regulator; (2) the counterparty
does not have significant swaps exposure; and
(3) the counterparty predominantly uses swaps or
security-based swaps to hedge or mitigate the risks
of its business activities, including balance sheet,
interest rate, or other risk arising from the business
of the counterparty.
CFTC CSEs would be required to apply haircuts to
any asset posted or received as margin (1) as
specified in the credit support arrangements with the
counterparty, or (2) that reflect the credit and
liquidity characteristics of the margined asset.
The third party independent custodian of the
margined assets would have to be located in a
jurisdiction that applies the same insolvency regime
11
Moreover, a foreign swap that has not been guaranteed by
an affiliate of the counterparty that is an entity organized under
the laws of the United States, branch or office of an entity
organized under the laws of the United States or persons that
are resident in the United States also would not be subject to
the margin requirements.
to the custodian as the CFTC CSE. Moreover, the
parties would be required to enter into an agreement
with the custodian to ensure that (1) neither the
CFTC CSE nor the counterparty rehypothecates
margined assets, (2) the custodian does not
rehypothecate margined assets, and (3) the
custodian does not reinvest the margined assets into
collateral that would not qualify as “eligible
collateral” as described above.
Extraterritoriality
Prudential Regulator Proposed Rules
The margin requirements of the Prudential
Regulator Proposed Rules would apply to all noncleared swap (and security-based swap) transactions
with a U.S. CSE (as described below) without
regard to whether the counterparty is located inside
or outside of the United States. The Prudential
Regulators stated in the proposing release for the
Prudential Regulators Proposed Rules that they have
adopted this approach because they believe that
swap transactions of a U.S. CSE create identical
risks to the U.S. CSE’s safety and soundness and to
the financial stability of the United States regardless
of whether the counterparty to the U.S. covered
swap entity is located in the United States or in a
foreign jurisdiction. A “U.S. CSE” for this purpose
would be a Prudential CSE that is not a foreign
CSE. A foreign CSE is defined in the Prudential
Regulator Proposed Rules as an entity that: “(1) is
not a company organized under the laws of the
United States or any State; (2) is not a branch or
office of a company organized under the laws of the
United States or any State; (3) is not a U.S. branch,
agency or subsidiary of a foreign bank; and (4) is
not controlled, directly or indirectly, by a company
that is organized under the laws of the United States
or any State.”
The margin requirements of the Prudential
Regulator Proposed Rules also would apply to all
non-cleared swaps (and security-based swaps) with
U.S. and foreign SDs, SB-SDs, MSPs and SB-MSPs
that are not Prudential CSEs where (1) the
counterparty is organized under U.S. law, (2) the
counterparty is otherwise located in the United
States or (3) a U.S. affiliate of the counterparty has
guaranteed the counterparty’s obligations under the
transaction. Whether a counterparty is controlled by
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Derivatives Practice Alert
a U.S. entity would not be an element used to
determine whether such counterparty is foreign.
Therefore, the Prudential Regulator Proposed Rules
would not apply to non-cleared swap transactions
between non-U.S. end users and non-U.S. banks as
long as: (1) the end user is a separate legal entity
organized under the laws of a foreign country and
not located in the United States; (2) the swap is not
guaranteed by an affiliate of the counterparty that is
organized under the laws of the United States or
State thereof or located in the United States; and
(3) the foreign bank is not (a) organized under U.S.
law or the law of any State, (b) a branch or office of
a company organized under the laws of the United
States or any State, (c) a U.S. branch, agency or
subsidiary of a foreign bank and (d) controlled,
directly or indirectly, by a company that is organized
under the laws of the United States or any State.
CFTC Proposed Rules
The CEA, as amended by the Dodd-Frank Act,
provides that the CEA “shall not apply to activities
outside the United States” unless those activities
“have a direct and significant connection with
activities in, or effect on, commerce of the United
States” or contravene CFTC rules promulgated to
prevent the evasion of the Dodd-Frank Act. The
CFTC Proposed Rules address the types of swap
counterparties that still would be subject to margin
requirements despite being foreign entities.
The margin requirements of the CFTC Proposed
Rules would apply to transactions between a U.S.
SD or MSP and any counterparty and would also
apply to transactions between any SD or MSP and a
“financial entity.” CFTC proposed Regulation
23.150 would define a financial entity as a
counterparty that is not an SD or MSP in a manner
generally similar to the definition in
Section 2(h)(7)(C) of the CEA that is used in
connection with a carve-out from any applicable
clearing mandate, but it includes three exceptions
from that requirement to address the CFTC’s
concerns about systemic risk to the United States.12
12
Section 2(h)(7)(C)(i) of the CEA defines “financial entity” to
include, in addition to an SD, an SB-SD, an MSP and an SBMSP, the following entity categories: (a) a commodity pool as
defined in CEA Section 1a(10); (b) a private fund as defined in
Section 202(a) of the Investment Advisers Act of 1940 (15
These exceptions: (1) add to the definition of
“financial entity” (a) entities that would be a
commodity pool or private fund if organized in the
United States or (b) any government of any foreign
country or any political subdivision, agency, or
instrumentality thereof; and (2) permit the CFTC to
designate additional entities as financial entities.
Additional Requirements
CFTC proposed Regulation 23.151 would require
CFTC CSEs to execute credit support arrangement
documentation consistent with the margin
requirements set forth in the CFTC Proposed Rules.
Items the documentation would specify include the
calculation of margin, the assets that could be
posted, margin thresholds and where such margin
would be held.
Capital requirements for swaps proposed by the
Prudential Regulators and the CFTC use the current
capital requirement regimes or postpone
formulating such requirements, respectively.13
Conclusion
By seeking to impose minimum credit support
requirements on swaps, the Proposed Rules
represent an important milestone in the effort to
implement Title VII of the Dodd-Frank Act. While
U.S.C. 80b-2(a)); (c) an employee benefit plan as defined in
paragraphs (3) and (32) of Section 3 of the Employee
Retirement Income Security Act of 1974 (29 U.S.C. 1002);
and (d) a person predominantly engaged in activities that are
in the business of banking or financial in nature, as defined in
Section 4(k) of the Bank Holding Company Act of 1956 (12
U.S.C. 1843(k)).
13
The Prudential Regulators already have capital
requirements in place for their regulated entities. The
Prudential Regulator proposing release notes that the Fed,
FDIC and OCC have had risk-based capital rules in place
since 1989 based on the Basel I Accord capital requirements,
and have been supplemented to reflect the evolution of
derivatives. The FCA and FHFA also have risk-based capital
methodologies in place. The Prudential Regulators propose
to rely on their existing rules regarding capital requirements,
which would be subject to future proposed rules that would
adjust their existing regulations to comport with the recently
developed Basel III regime.
The proposing release for the CFTC Proposed Rules states
that the CFTC will propose capital requirements at a later
date; it should be noted, however, that the CFTC did propose
rules regarding capital requirements during its April 27, 2011
meeting.
May 2011
8
Derivatives Practice Alert
the regulatory focus of the CFTC and the Prudential
Regulators is on the stability of the United States
financial system, the Proposed Rules could impose
significant costs on market participants that could
adversely affect economic growth and employment.
This is particularly the case in respect of commercial
end users in capital-intensive industries that may be
forced to balance their hedging needs and their need
for liquidity in new ways. The differences between
the CFTC approach and that of the Prudential
Regulators may expose end users to enhanced
regulatory risk that may affect their models for cash
management, capital formation and hedging
activities. Considering that the financial crisis was
arguably caused by financial institutions that are
dealers rather than by end users, it is ironic that the
costs of stability could be imposed largely on end
users.
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May 2011
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