SIFMA Provides Notice to Banking Regulators on Treatment of CCPs' Variation Margin
Commentary by Steven Lofchie
SIFMA provided notice to banking regulators (the Board of Governors of the Federal Reserve, the Office of the Comptroller of the Currency and the FDIC) of a forthcoming change in the treatment of variation margin payments for over-the-counter derivatives by central clearing counterparties ("CCPs"). Historically, variation margin payments have been treated as collateral for outstanding exposure, a treatment that a SIFMA comment letter refers to as the "collateralized to market" ("CTM") model. Going forward, the CCPs will adopt a model by which variation margin payments are treated as settlement of the exposure under the contract, a treatment that the SIFMA comment refers to as the "settled to market" ("STM") model.
According to SIFMA, it is expected that in addition to the CCPs, other market participants will amend or clarify their terms, rules and procedures to determine circumstances under which the payment of variation margin for cleared derivatives will be deemed to constitute settlement of any exposure under the agreement, as opposed to collateralization of the outstanding exposure.
The SIFMA comment letter states that while "both models achieve the same expose-mitigating objective, they differ in their implications for the rights and obligations of the counterparties." The STM model is "recognized as preferable to the CTM model within the regulatory capital framework" and results in "clearing member firms having higher capital and supplementary leverage ratios" SIFMA stated. The following steps are "typically pursued by clearing member firms" prior to considering a cleared OTC derivative contract to be executed under the STM model:
- verifying that the CCP terms, rules, and procedures, as approved by the CCP's primary regulator, and the terms of their client clearing agreements, are consistent with the STM model;
- working with in-house and outside counsel to review such terms, rules, and procedures, and obtain legal analysis that the relevant derivative contracts are STM;
- working with internal and independent accountants to determine the appropriate accounting treatment for relevant exposures and payments; and
- coordinating with impacted internal functions (e.g., tax, operations, financial reporting, risk, etc.) to reflect derivative contracts as STM rather than CTM, as appropriate.
Commentary
The need for this change in the documentation of contracts is driven by the fact that the banking regulators previously took a fundamentally punitive and economically unsound position with respect to the regulatory capital treatment of collateral for cleared derivatives. As the banking regulators stretch their regulatory authority into new types of transactions (e.g., cleared derivatives), the limits of their pre-existing regulatory expertise become clear.
Recently, the banking regulators acknowledged that central clearing creates a number of systemic risks that they failed to anticipate (although they should have done so). Conversely, the banking regulators' treatment of collateral for cleared derivatives (effectively treating posted collateral as if it were a loan of assets to the secured party) has been likewise faulty, in effect, treating a risk-reducing transfer, as if it were risk-increasing.