The Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) continue to issue regulations implementing the OTC derivatives provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank). In a Q&A, Robin Powers of the Rimon Law Group discusses Title VII of Dodd-Frank and its impact on margin/collateral posed by End-Users.
Q. How does Dodd-Frank Address Collateral Risk for Uncleared Swaps?
Dodd-Frank mandates that (registered) swap dealers and major swap participants (collectively, Dealers) notify unregistered swap counterparties (End Users) that an End User has the right to require the segregation of funds and other property posted by the End User as collateral to secure its obligations under swap transactions. If the End User so elects, the Dealer is required to set aside and separately manage the collateral for the benefit of the End User. Dodd-Frank requires that the segregated account must be carried by an independent third-party custodian and designated as a segregated account for and on behalf of the End User. The choice of the custodian is left to the parties. The proposed CFTC rule allows an affiliate of either the Dealer or the End User to serve as a custodian for initial margin for an uncleared swap to which the affiliate custodian itself was not a party. In the rules release, the CFTC explained that the proposed rule permits affiliates to serve as custodians in order to allow parties to engage in swap transactions with affiliates of their typical custodians. However, this permissive stance may increase pressure from Dealers for segregated accounts to be held at their affiliated custodians, rather than at third party entities.
The proposed CFTC rule further requires that any segregation agreement be in writing and that the custodian be a party to the agreement. The written agreement must provide that the custodian will release margin from the segregated account in one of only two ways: either pursuant to agreement between the Dealer and End User, or upon the custodian’s receipt of a written request from the party entitled to seek the release (under oath and penalty of perjury) made pursuant to an agreement between the parties, with a notice about the release immediately sent to the other party. The proposed rule does not include any requirements as to when the segregation agreement must allow (or may not allow) release of assets from the account; for example, there is no requirement that an End User be able to require release of assets from the account in the event of the Dealer’s default. Presumably, these requirements would be subject to negotiation amongst the three parties.
If the End User elects not to require segregation of its collateral, the Dealer must certify to the End User on a quarterly basis that the margin and collateral operations of the Dealer are in compliance with the agreement of the parties. It remains to be seen whether Dealers will in fact be able to monitor their compliance in order to be able to make the necessary certification.
Q. Who will Bear the Cost of Segregating Collateral?
The CFTC is currently contemplating whether to require that Dealers disclose the costs of segregation to End Users, whether the costs are reflected in custodial fees for segregated assets or price adjustments offered for renouncing segregation. The CFTC has not indicated that there will be limitations on the costs imposed for segregated accounts, and End Users may find the use of segregated accounts cost prohibitive.
Q. How Does the Requirement for Uncleared Swaps Differ from Collateral Held for Cleared Swaps?
Dodd-Frank requires that collateral posted to secure obligations related to cleared swaps be held by a designated clearing organization (DCO), a registered futures commission merchant (FCM for swaps), or a broker, dealer or security-based swap dealer (Dealer for security-based swaps). This collateral must be treated as belonging to the End User, be separately accounted for, and not be commingled with the funds of the DCO, FCM or Dealer or be used to margin, secure or guarantee any trades or contracts of any swap customer other than the End User for whom the collateral is held.
DCOs and FCMs currently have margin systems in place based on the futures model that allows customer collateral to be commingled in an omnibus account. Under this model, once a defaulting customer’s collateral has been exhausted and the FCM has failed to make the DCO whole, collateral of other customers of the FCM may be used to meet the FCM’s obligations to the DCO (what the CFTC has termed “fellow-customer risk”). This fellow-customer risk, however, poses additional counterparty credit risk for End Users.
In response to this End User concern, the CFTC has requested comments on four models that offer different degrees of protection for customer collateral against fellow-customer risk:
1) The current futures model, as described above.
2) A model that is similar to the current futures model, except that before any non-defaulting customer collateral is used to cover a fellow-customer loss, the DCO must first tap into the DCO’s guaranty fund. Under this model, a customer would be subject to fellow-customer risk only in the most extreme of circumstances (when a default has consumed the entire DCO guaranty fund).
3) A model under which collateral of multiple customers could be commingled in an omnibus account, but the collateral in the account would be attributed to individual customers based on the collateral requirements for the specific customer’s swaps. Under this model, following a loss from a fellow-customer, each non-defaulting customer would receive from the omnibus account the current value of collateral attributed to it (or have such amounts transferred to another FCM). However, that amount recovered will not necessarily be the same as the amount of collateral previously posted by the customer to the FCM due to market fluctuations in the value of the collateral. As a result, collateral of a non-defaulting customer could be at risk for a decline in market value of its collateral and the collateral of fellow customers in an FCM’s omnibus account, but should not be subject to fellow-customer risk described above .
4) A model requiring individual segregation of each customer’s collateral at all levels (at the FCM, DCO, and at each custodian), similar to the uncleared swap mandate.
The costs associated with each of the possible segregation models is discussed at length in ISDA’s comments letter to the CFTC “In Re: RIN No. 3038-AD99 - Advanced Notice of Proposed Rulemaking —Protection of Cleared Swaps Customers Before and After Commodity Broker Bankruptcies (75 Fed. Reg. 75162), January 18, 2011. http://www.isda.org/speeches/pdf/CFTC-ANPR-Protection-for-Cleared-011811...
Q. Do the Dodd-Drank Segregation Requirements Apply to all Collateral Margin Posted by an End User?
The Dodd-Frank segregation requirement for uncleared swaps applies only to initial margin and not variation margin.
End users engaged in swap transactions typically have two components to their collateral/margin requirements: initial margin or “Independent Amount” and variation margin or “mark-to-market.”
Initial margin, or Independent Amount, is collateral held by one party primarily to protect against the risk that the other party will fail to meet obligations to make future variation margin transfers and the corresponding time needed to close out the defaulting party’s positions. It reflects counterparty credit risk, the volatility of the product being traded and shortfalls in variation margin due to large market movements, minimum transfer amounts, thresholds and other factors. As many End Users experienced in the Lehman Bankruptcy, if a counterparty holding initial margin becomes insolvent, the party that posted that initial margin will be an unsecured creditor with respect to the return of the initial margin, unless it has entered into a custodial or other segregation agreement for protection of that initial margin. Dodd-Frank’s segregation requirements are intended to offer some protection against this risk.
Variation margin or “mark-to-market” related to a swap transaction represents collateral in an amount equal to what one party to the swap would owe the other if the swap were to be closed out on any given day. Variation margin ensures that if an “out-of-the-money” party defaults, the “in-the-money” party is holding sufficient collateral to cover its exposure to the defaulting counterparty. If properly (and frequently) calculated, variation margin represents the amount a posting party will owe the other upon a default by either party, and therefore is generally not considered to be collateral at risk of loss by a posting party.
Q. Does Dodd-Frank Offer Enough Protection for Uncleared Swap Collateral?
Many issues raised by the Dodd-Frank’s segregation requirements for uncleared swaps will need to be clarified prior to implementation. One key question is how an independent third-party custodian will be defined. With an unaffiliated custodian, it is less likely that the secured party and custodian will become insolvent at the same time. However this term is defined, End Users will need to be mindful of the additional layer of insolvency risk introduced by the use of a custodian.
Additionally, Dodd-Frank does not appear to require customer assets to be segregated on an individual customer basis, but rather in omnibus customer accounts where customer assets are pooled. Individually segregated accounts may be more secure, in that it is less likely that any customer will share in losses due to another customer’s shortfall causing a deficiency in the aggregate funds available to settle all customer claims. However, the administrative and operational costs of individual segregation will likely be greater than in an omnibus account arrangement.
Q. Will Customers be Able to Negotiate Additional Protections?
End Users should pay attention to additional protections that may address specific risks or concerns including: (i) whether the End User will be subject to intraday collateral calls; (ii) when a secured party and/or custodian may exercise remedies; (iii) whether notice periods relating to collateral calls will be required or specified; (iv) whether the End User must wait for some period of time before instructing the custodian to return assets following default of the Dealer; (v) whether and under what terms collateral may be substituted; (vi) the standard of care the custodian must use in holding collateral; and (vii) under what circumstances, if any, collateral may be rehypothecated (or used) by either the secured party or the custodian.
Q. Will Margin Rates be Set by Regulators, Dealers or by Both?
Margin rates on cleared swaps will be set by the specific clearinghouse. Dealers are likely to require an additional cushion of collateral on top of the mandated amount in order to protect themselves against clients, individually and collectively across a Dealer’s client base, not posting collateral when it is required. The rate charged for additional collateral, and whether any specific End User will be subject to the requirement, will likely be subject to bilateral negotiation based on the End User’s credit profile and the extent of its relationship with the Dealer.
Q. What are the Implications for a Portfolio Consisting of Cleared and Uncleared Swaps?
There is the potential over time for cross margining of different product types within a clearing house. Dealers may also be able to cross margin cleared and uncleared transactions across asset classes with respect to the additional collateral that is held outside of the clearing system. But even where the level of collateral required for a portfolio, based on a value at risk model, across all cleared and uncleared transactions is less than the collateral required by the clearing houses for the cleared swaps, End Users will not be able to consider their total collateral requirement on a portfolio basis. At best, “portfolio margining” as is currently practiced is a very long term goal in the bifurcated world of cleared and uncleared swaps.
For most End Users, clearing only a portion of their swaps within a portfolio will become a burden, both operationally and with respect to the cost of collateral. End Users who will be required to centrally clear some of their transactions will likely look to move as much activity as possible into a centrally cleared arrangement. We should expect to see at least a short term drop in OTC trading volumes as End Users readjust their trading and back office models to recognize higher collateral requirements, and cost tradeoffs between cleared and uncleared swaps. Over time, however, End Users are likely to become more able and willing to use OTC products that offer more client money protection and less Dealer counterparty risk.
Robin's focus is financial transactions entered into by hedge funds and other financial institutions, with an emphasis on derivatives, prime brokerage and securities lending agreements. Prior to Rimon, Robin was an attorney at Sutherland Asbill & Brennan.
Robin has extensive experience negotiating and documenting International Swaps and Derivatives Association (ISDA) master agreements, master repurchase agreements, collateral and other credit support documents, prime brokerage agreements, and securities lending agreements. She assists clients in their various transactional activities including documentation of structured transactions, credit default swaps, equity derivative transactions, interest rate swaps, asset swaps, total return swaps and currency transactions. She also has developed master confirmations for various derivative products.
Robin has experience in structuring and organizing domestic and offshore investment funds including the design, structure and operation of investment portfolios. She also provides ongoing advice to investment advisory clients relating to their investment products and services and trading issues. Robin further assists both investment fund and investment advisory clients in the negotiation and documentation of agreements with service providers including administrators, data and electronic trading service providers, auditors, and prime brokers.
Robin’s extensive representative experience includes:
- Representing a number of hedge fund families and other end-user clients on documentation for all derivatives products, master securities loan agreements, global and overseas lending agreements, prime brokerage arrangements, give-up arrangements and master netting agreements.
- Regularly advising end users on practices to minimize counterparty risk and assisted clients with the termination of derivative and cash trades in a dealer bankruptcy.
- Representing a credit fund in structuring and negotiating a $500 million total return swap (TRS) based on a portfolio of loans and frequently advising on the structuring, negotiation and documentation of TRS facilities.
- Updating templates for documentation of derivatives transactions on behalf of a variety of clients including hedge funds, mutual funds and insurance companies.
- Negotiating on behalf of funds and other end-user clients to avoid termination of derivatives transactions due to significant net asset value decline.
Representing a hedge fund and other end-user clients in a wide range of disputes involving collateral valuation, ISDA events of default and early terminations, secondary loan trading, novations and fund liquidations.