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CFTC Staff Provides Guidance on Application of Swaps Initial Margin Thresholds

nihal.patel@cwt.com's picture
Commentary by Nihal Patel

The CFTC Division of Swap Dealer and Intermediary Oversight ("DSIO") clarified that "Phase Five" initial margin ("IM") documentation requirements will not apply to trading relationships where initial margin requirements have not gone above the $50 million threshold. As previously covered, CFTC Chair J. Christopher Giancarlo urgedU.S. regulators (including banking regulators) to provide relief of this nature.

The advisory states that, while no specific documentation is required, it is expected that swap dealers will have required documentation in place when the threshold is reached. The advisory provides the following additional guidance on relevant requirements:

  • Noting that Rule 23.504 ("Swap Trading Relationship Documentation") requires appropriate steps to ensure timely execution of IM documentation as required by the CFTC margin rules, the advisory states that if a swap dealer opts to post IM below the threshold it must require that the collateral be held at an independent custodian in accordance with CFTC Rule 23.157(c) ("Custodial arrangements").

  • Under CFTC risk management requirements of Rule 23.600 ("Risk Management Program for Swap Dealers and Major Swap Participants"), swap dealers must "act diligently" as IM requirements approach the threshold to ensure compliance and have required documentation in place.

  • In light of these requirements and requirements under CFTC Rules 23.504 and 23.158 ("Margin Documentation"), DSIO states that it believes that the rules require execution of IM documentation when collection or posting is actually required - i.e., when the threshold is reached.

Commentary

The DSIO advisory has been long expected and, given Mr. Giancarlo's previous letter to the "prudential regulators," it seems reasonable to expect that similar relief should be granted for the prudential regulators' parallel rules.

However, one aspect of the advisory is curious. DSIO seems to be saying that any IM posted by a swap dealer - even if not required under the rules (i.e., below the threshold) - must be held at a third-party custodian in accordance with CFTC requirements. This is a plausible interpretation of the text of Rule 23.157. The posting provision of that regulation, 23.157(a), addresses "initial margin" posted by a swap dealer, but the collection provision, 23.157(b) specifically references "initial margin required by 23.152" (emphasis added). Rule 23.150 defines "initial margin" as collateral "calculated in accordance with 23.154."

It is possible that the DSIO advisory is intended to say that if a swap dealer posts IM to a counterparty, calculated as though it were subject to the rule requirements, it must be held at a third-party custodian. But even that would be inconsistent with a statement in the adopting release for the margin requirements (at 670), which says that (1) 23.157(a) "requires a [swap dealer] that posts any collateral required under the final rule other than variation margin" to have it held at a third-party custodian and (2) the third-party custodian requirement applies to "[IM] posted by a [swap dealer] pursuant to Rule 23.152." In other words, in interpreting 23.157(a) at the time of adoption, the CFTC clearly intended it to apply only to IM required under the regulations.

There are a handful of plausible readings of the text of 23.157(a), and DSIO seems to be taking one that requires at least some unregulated IM posted by a swap dealer to be held at a third-party custodian. To be sure, swap dealers posting unregulated IM to counterparties is not especially common. However, it does occur, and the advisory seems to inject a degree of uncertainty as to how the rules apply in that circumstance.

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