Second Annual
SIFMA Asset Management Derivatives Conference
May 22, 2013
Uncleared Margin Requirements for Swaps
Daniel N. Budofsky
Partner, Davis Polk & Wardwell LLP
Uncleared Margin Requirements in the Dodd-Frank Act
 For uncleared swaps, the Dodd-Frank Act imposes initial and variation margin
requirements on swap dealers and major swap participants.

The prudential regulators (Fed, FDIC, OCC, FCA and FHFA) will set margin
requirements for banking entities in consultation with the CFTC and SEC.

The CFTC and SEC will set margin requirements for other entities.
 None of these agencies have finalized their margin rules.

We expect that margin rules will be coordinated both among these agencies and with
international regulators, particularly BCBS and IOSCO.
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Uncleared Margin Requirements in the Dodd-Frank Act
 Counterparties are divided into the following categories:
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swap entities;
high-risk financial end users;
low-risk financial end users; and
nonfinancial/commercial end users.
 Persons accepting customer collateral as margin for cleared swaps must
register as an FCM.
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CFTC and Prudential Regulators' Uncleared Margin
Proposals (April 2011)
 The proposed rules require swap entities to collect margin from their
counterparties rather than post margin to their counterparties.

As a result, margin requirements are unilateral.
 The amount of margin required to be collected, the frequency of collection of
variation margin and the segregation requirements for collected margin depend
primarily on the type of counterparty.
 At the election of an end-user, swap dealers must have margin for uncleared
swaps held at an independent third-party custodian.
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Proposed Uncleared Swap Margin Requirements
SWAPS BETWEEN SWAP ENTITIES
 Under both rules, for swaps between two swap entities:
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Both swap entities must collect initial and variation margin from each other.
Margin is required without a minimum threshold.
Margin must be segregated at a third-party custodian.
 The prudential regulators' rule has a number of additional requirements.

The custodian must be independent and located in a jurisdiction that would apply the
same insolvency law to the custodian as it would apply to the bank swap entity that is
entitled to receive the collateral.

Initial margin cannot be offset by initial margin owed by the bank swap entity to its
counterparty.

Segregated margin cannot be rehypothecated or invested in assets other than eligible
investments.

Variation margin must be collected at least once per business day.
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Proposed Uncleared Swap Margin Requirements
SWAPS WITH FINANCIAL END USERS
 Under both sets of proposed rules, swap entities would be required to collect
initial and variation margin from financial end users, but would not be required
to post initial or variation margin to financial end users.

The CFTC has stated it will use the definition of "financial entity" from Title VII of
Dodd-Frank.

The prudential regulators have proposed a definition of "financial end user", similar to
the Dodd-Frank definition but that explicitly includes foreign governments and political
subdivisions.
 The prudential regulator proposal divides financial end users into "high-risk
financial end users" and "low-risk financial end users" and applies different
margin standards to each.
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Proposed Uncleared Swap Margin Requirements
LOW-RISK AND HIGH-RISK FINANCIAL END USERS
 A financial end user qualifies as "low risk" if it:
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does not have "significant swaps exposure" (half of the MSP threshold);
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is subject to capital requirements established by a prudential regulator or state insurance
regulator.
predominantly uses swaps to hedge or mitigate the risks of its business activities, including
balance sheet, interest rate, or other risk arising from its business; and
 For swaps between a swap entity and a "low-risk financial end user":
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The swap entity must collect initial and variation margin but is not required to post margin.
Margin will not need to be posted for uncollateralized counterparty swap exposure that does not
exceed a threshold set through credit exposure limits.
 The prudential regulators indicated that this threshold would be set at the lesser of between $15 and
$45 million and 0.1% to 0.3% of regulatory capital in the final rule.

The swap entity must allow its counterparty to opt into independent third-party segregation for
initial margin.

Variation margin must be collected only once per week by bank swap entities, whereas "high-risk
financial end users" must have variation margin collected at least once per business day by a
bank swap entity.
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Proposed Uncleared Swap Margin Requirements
NONFINANCIAL END USERS
 Margin requirements for swaps with nonfinancial / commercial end-users vary
between the prudential regulators' and the CFTC's proposed rules:

Under the prudential regulators' proposal, bank swap entities must set their own
credit exposure limits for nonfinancial end users and must collect collateral to the
extent calculated margin requirements exceed those limits.

Under the CFTC proposal, nonfinancial end users are not required to post any
margin, though the counterparties must enter into a credit support agreement.
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Swap Margin Calculation
INITIAL MARGIN
 Both sets of proposed rules allow swap entities to use models to calculate the
amount of initial margin they require from counterparties.
 The prudential regulators would allow bank swap entities to use internal
models meeting specified criteria that have been approved by their prudential
regulator.
 The CFTC would require the model to be approved by the CFTC and be:
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used by a derivatives clearing organization for clearing swaps;
used by an entity subject to oversight by a prudential regulator; or
made available for licensing to any market participant by a vendor.
 In both cases, the models would be required to cover exposure over a 10-day
default window in 99% of cases, longer than the 3-5 day window generally
used by clearinghouses.
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Swap Margin Calculation
INITIAL MARGIN – FALLBACK OPTIONS
 Both sets of proposed rules have different fallback options if such internal
margin models are not used.
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The prudential regulators would require the use of a grid that sets margin
requirements as a percentage of the notional amount of the swap, with the
percentage varying based on the type of swap.

The CFTC would require CFTC-regulated swap entities to multiply the margin
required for a comparable cleared swap by a specified factor to determine the amount
of margin required to be posted.
 As a practical matter, it seems unlikely that many swap entities will use these
fallback options as they do not allow for the efficiencies of offsetting positions.
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Swap Margin Calculation
VARIATION MARGIN
 The prudential regulators' proposed rules calculate the amount of variation
margin to be collected as the mark-to-market change in value of a swap from
the date it is entered into minus the value of all variation margin previously
collected but not returned by the swap entity on that swap.
 In general, bank swap entities may net across all swap or security-based swap
transactions entered into with a counterparty under a "qualifying master netting
agreement."
 The prudential regulators' proposed rules also require counterparties to specify
in their trading documentation the "methods, procedures, rules and inputs" they
use to determine the value of swaps for variation margin purposes, as well as
how disputes will be resolved.
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SEC Proposal for Margin for Uncleared Security-based
Swaps
The Proposal would require Nonbank SBSDs to collect margin for uncleared SBS
from each of its counterparties to cover current and potential future exposure
(i.e., variation and initial margin, respectively) to the counterparty, subject to
exceptions.
 Under the Proposal, an SBSD would be required to perform daily margin calculations for
accounts of uncleared SBS counterparties to determine the amount of current exposure
in the account and the potential future exposure for the account; more frequent
calculation would be required under certain circumstances.
 On the business day following such calculation, an SBSD would be required to collect
eligible collateral from its counterparties in an amount at least equal to the negative
equity (current exposure or variation margin) in the account plus the margin amount
(potential future exposure or initial margin), resulting in the SBSD’s counterparty
maintaining a minimum level of positive net equity in the account.
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SEC Proposal for Margin for Uncleared Security-based
Swaps (continued)
“Current exposure” means the current replacement value of the counterparty’s
positions with the SBS dealer, after giving effect to qualifying netting agreements
and taking into account the value of collateral held by the SBS dealer.
 The collateral collected by an SBSD must be in the form of cash, securities, or money
market instruments, although prescribed haircuts would apply to securities and money
market instruments.
 The method for determining the margin amount would be similar to the approach that an
SBSD would use to determine haircuts on proprietary SBS when calculating its net
capital requirement, i.e., by using standardized haircuts or internal models (depending on
whether the SBSD is approved to use internal models). Even if an SBSD is approved to
use internal models, the margin amount for equity SBS must be determined exclusively
using standard haircuts.
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Basel/IOSCO Consultation Papers
(July 6, 2012)
 On July 6, 2012, the Basel Committee on Banking Supervision (“BCBS”) and the
International Organization of Securities Commissions (“IOSCO”) issued a consultation
paper on margin requirements for uncleared derivatives. This initial BCBS/IOSCO paper
differed substantially from the prudential regulators' and CFTC's proposals, including
recommending:
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a broader scope,
bilateral margin exchange, and
segregation of initial margin or equivalent protections as well as a ban on rehypothecation in all
cases.
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Basel/IOSCO Consultation Papers
(February 15, 2013)
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On February 15, 2013, BCBS and IOSCO released a second consultative paper in response to public
comment and their quantitative impact study of the effect of the initially proposed margin requirements
on 39 large financial institutions. The revised initial margin requirements would
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apply only to entities in consolidated groups with more than €8 billion of uncleared derivatives exposure;
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apply to all uncleared derivatives, including those that are not “swaps” or “security-based swaps” subject to Title
VII of the Dodd-Frank Act, such as options on securities.
allow for a €50 million initial margin threshold between consolidated groups;
phase in initial margin requirements between 2015 and 2019 (beginning in 2015 with swaps between consolidated
groups that each have more than €3 trillion in notional swaps outstanding); and
BCBS and IOSCO have, however, requested comment on whether to exempt physically settled
foreign exchange forwards and swaps from the margin requirements that apply to other non-centrally
cleared derivatives, consistent with the U.S. Treasury Secretary’s exclusion of these instruments from
most swap regulation, including uncleared margin requirements. BCBS and IOSCO have proposed
exempting sovereigns, central banks, multilateral development banks and the Bank for International
Settlements from margin requirements.
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Summary Comparison of Margin Proposals
for Uncleared Derivatives
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Summary Comparison of Margin Proposals
for Uncleared Derivatives (continued)
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Summary Comparison of Margin Proposals
for Uncleared Derivatives (continued)
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Summary Comparison of Margin Proposals
for Uncleared Derivatives (continued)
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