The House is continuing Congress’ piecemeal rollback of the Dodd-Frank Act, a theme Alexander Sand and I explore in our recent article, Cutting Back: Revisions to Dodd-Frank Derivatives Rules.[1] Although the House has targeted a number of Dodd-Frank provisions for regulatory relief, today I will focus on clearing and margin. At present, these requirements are not harmonized in that market participants that are exempt from clearing may nevertheless be forced to post margin when trading with swap dealers and major swap participants (the two types of market intermediaries that are subject to margin requirements under Dodd-Frank). Imposition of margin requirements for a swap exempted from clearing has the potential to nullify the benefit a party claiming the clearing exemption might otherwise receive.
Clearing
The Dodd-Frank Act added provisions to the Commodity Exchange Act requiring mandatory clearing of categories of swaps designated by the Commodity Futures Trading Commission (“CFTC”).[2] In December, 2012, the CFTC mandated the clearing of the most commonly traded interest rate swaps and some index credit default swaps.[3] Since then, no further swap categories have been designated as subject to mandatory clearing.[4]
While requiring mandatory clearing for categories of swaps designated by the CFTC, the Dodd-Frank Act also provided some counterparty types the option of declining clearing by making them exempt from mandatory clearing. Most notably, non-financial end-users using a swap to hedge are exempt from mandatory clearing requirements.[5]
Margin
The Dodd-Frank Act also amended the Commodity Exchange Act to require that those swap transactions that are uncleared are subject to margin requirements when entered into with a swap dealer or major swap participant.[6]
The concept of margin for uncleared swaps, as enshrined in the Dodd-Frank Act, was inspired by the existing margin regime for futures (and, now, cleared swaps). Margin for uncleared swaps is accordingly divided into “variation” and “initial” margin.
Variation Margin
The underlying theory is that “variation margin” should be provided to collateralize the mark-to-market exposure one party has to the other. In other words, if all swap transactions between A and B were terminated today, who would owe whom a settlement amount and how much? Supposing that A would owe B $500, A would be required to provide B $500 in variation margin so that, if the transactions were terminated for some reason, B would be made whole with the margin A has posted.
What if the next day B’s hypothetical exposure to A increased to $1,500? Then A would owe B $1,000 more in variation margin. If the exposure of B to A subsequently decreased, B would be required to return margin to A. Of course, if the exposure switched so that A were exposed to B, B would be the party providing variation margin.
Initial Margin
Returning to the example where A owes B $1,000 in additional variation margin, there is always the risk that A refuses to pay B the additional variation margin it owes. This is where initial margin comes in. Initial margin is an upfront amount intended to cover nearly all anticipated exposure changes that may occur between variation margin calls. Therefore, a swap that is historically volatile will have a higher initial margin requirement.
The relevant regulators still need to finalize margin rules. Until they do so, the methodologies required to be used to calculate initial and variation margin are not known.
Margin and its Relation to Clearing
Another theory underlying margin – not clearly enunciated by the Dodd-Frank and leading to some confusion among regulators[7] – is that margin should only be required by entities other than non-financial end-users. One way to simplify this is, if an entity can claim the end-user exemption from clearing, it should be similarly exempt from margin.
To add a layer of confusion, in the area of capital requirements and margin requirements for CFTC swap registrants, the “prudential regulators,” i.e., the Federal Reserve Board, Office of the Comptroller of the Currency, Federal Deposit Insurance Corporation, Farm Credit Administration, and Federal Housing Finance Agency, have the collective authority to promulgate capital and margin rules for entities under any of their jurisdictions and the CFTC has the authority to promulgate the capital and margin rules for all other CFTC swap registrants.[8]
Both the CFTC and prudential regulators have proposed margin rules.[9] However, as Alexander Sand and I have highlighted in Cutting Back: Revisions to Dodd-Frank Derivatives Rules, the entities that, as a matter of statute, rulemaking, or CFTC no-action relief, are exempt from clearing are broader in scope than those exempted from margin requirements. This is despite Congress partially rectifying this disparity with the Business Risk Mitigation and Price Stabilization Act of 2015 by providing statutory margin exemptions for nearly every entity type that, at the time of its passage, had an exemption from clearing.[10]
House Bill
The CFTC is periodically reauthorized by Congress. Its last reauthorization expired in September, 2013.
Earlier this month the House of Representatives passed a reauthorization bill that expands the scope of the clearing exemption and, except for entities using the “inter-affiliate” clearing exemption, would make all entities currently eligible for an exemption from clearing eligible for an exemption from margin requirements. For entities using the “inter-affiliate” exemption from clearing (an exemption from clearing for affiliated entities), there is no automatic corresponding margin exemption and, in the CFTC’s and prudential regulators’ margin proposals, no exemption for such entities is contemplated.
The table below summarizes the legal interrelationship between the clearing exemptions and margin exemptions:
| Summary of Clearing and Margin Exemptions | ||||
| Clearing Exemption | Statutory and Regulatory Basis for Clearing Exemption | Exemption from Margin Requirements Proposed by CFTC and Prudential Regulators? | Exemption from Margin Requirements Provided by the Business Risk Mitigation and Price Stabilization Act? | Exemption Proposed to be Provided by H.R. 2289, the Commodity End-User Relief Act? |
| Commercial End-User | Commodity Exchange Act § 2(h)(7)(A) & 17 C.F.R. § 50.50 | Yes | Yes | N/A |
| Commercial End-User Affiliate | Commodity Exchange Act § 2(h)(7)(D) | Yes | Yes | See Treasury Affiliate below |
| Captive Finance Company | Commodity Exchange Act § 2(h)(7)(C)(iii) | Yes | Yes | Existing clearing exemption broadened to include “commercial market participants” |
| Cooperative | Commodity Exchange Act § 3(c) & 17 C.F.R. § 50.51 | No | Yes | N/A |
| Inter-affiliate | Commodity Exchange Act § 3(c) & 17 C.F.R. § 50.52 | No | No | No |
| Small Bank | Commodity Exchange Act § 2(h)(7)(C)(ii) & 17 C.F.R. § 50.50(d) | No | Yes | Existing clearing exemption broadened to include holding companies of small banks |
| Treasury Affiliate | CFTC No-Action Letter 14-144 | No | No | Existing clearing exemption made statutory by expanding scope of commercial end-user affiliate exemption |
Regulatory Reform on the Decline?
The piecemeal congressional effort to harmonize clearing and margin exemptions, and to enshrine some exemptions that were the result of regulation or regulatory staff action into statute, is consistent with a greater theme of reevaluating elements of the Dodd-Frank regulatory regime. The high water mark of financial market regulation seems to have passed – for now.
ENDNOTES
[1] Gary E. Kalbaugh & Alexander F. L. Sand, Cutting Back: Revisions to Dodd-Frank Derivatives Rules, 35 No. 3 Futures & Derivatives L. Rep. 1 (forthcoming June, 2015).
[2] Commodity Exchange Act § 2(h).
[3] Commodity Future Trading Commission, Clearing Requirement Determination Under Section 2(h) of the CEA, 77 Fed. Reg. 74284.
[4] The clearing of non-deliverable forwards, i.e., foreign exchange swaps or forwards that are cash-settled, is under consideration. Opening Statement Chairman Timothy G. Massad before the Global Markets Advisory Committee Open Meeting (Oct. 9, 2014), available at http://www.cftc.gov/PressRoom/SpeechesTestimony/massadstatement100914 (last visited June 13, 2015). Physically-settled foreign exchange swaps and forwards are exempt from clearing. See Commodity Exchange Act § 1a(47)(E)(iv) and Determination of Foreign Exchange Swaps and Foreign Exchange Forwards under the Commodity Exchange Act, 77 Fed. Reg. 69694.
[5] Commodity Exchange Act § 2(h)(7)(A) & 17 C.F.R. § 50.50. The other exemptions are enumerated in the table below.
[6] Commodity Exchange Act § 4s(e).
[7] In 2011, the CFTC and prudential regulators took opposite positions on whether non-financial end-users were statutorily required to post margin when trading with CFTC swap registrants. See Margin and Capital Requirements for Covered Swap Entities, 76 Fed. Reg. 26564, 26569-26570 and Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 76 Fed. Reg. 23732, 23736-23737. Both submitted new proposals in 2014 recognizing an exemption from margin requirements for non-financial end-users.
[8] Commodity Exchange Act § 4s(e).
[9] For the CFTC’s proposal, see Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 79 Fed. Reg. 59858. For the prudential regulators’ proposal, see Margin and Capital Requirements for Covered Swap Entities, 79 Fed. Reg. 57347.
[10] Business Risk Mitigation and Price Stabilization Act of 2015, Pub. L. 114-1, § 302(a).
The preceding post comes to us from Gary E. Kalbaugh, Director and Assistant General Counsel at ING Financial Holdings Corp .and Special Professor of Law at the Maurice A. Deane School of Law at Hofstra University. The post is based on his article, coauthored with Alexander F. L. Sand, entitled “Cutting Back: Revisions to Dodd-Frank Derivatives Rules” and available here.