Protection of Collateral for Uncleared Swaps—the Importance of Initial Margin Segregation

On November 6, 2013, the U.S. Commodity Futures Trading Commission (“CFTC”) published final rules that require swap dealers and major swap participants (“Registered Entities”) to notify end-users of their right to require segregation of initial margin for uncleared swaps (the “Final Rules”). [1] The Final Rules give end-users more bargaining power in the negotiation of swaps margin terms with Registered Entities and will minimize the likelihood of another Lehman Brothers scenario in which end-user collateral was difficult to identify, trace, and recover.

Uncleared Swaps and Collateral
Despite the move to central clearing of over-the-counter (“OTC”) derivatives, uncleared OTC derivatives continue to be widely used risk management tools for corporations, pension funds, insurance companies, financial institutions, and limited recourse entities used in securitizations. Without uncleared swaps, users of these products may experience greater earnings volatility due to an inability to qualify for hedge accounting, or be unable to offset the interest rate, inflation, and longevity risks posed by long-dated pension or insurance liabilities. Regulators, both domestically and abroad, have proposed rules recommending the exchange of margin for uncleared swaps by certain categories of end-users and have long recognized the importance margin has in the reduction of systemic risk. [2]

Collateral is a key mitigant of counterparty risk in both cleared and uncleared swaps. Collateral consists of margin that is posted over time to cover the current exposure arising from changes in the market value of the position since the trade was executed or the previous time the position was marked-to-market (“Variation Margin”) and initial margin, which is transferred at the outset of a transaction as a performance bond to cover potential future exposures arising from changes in the market value of the position (“Initial Margin”). Historically, most collateral arrangements under bilateral uncleared swaps were one-way obligations for end-users but over time have evolved into two-way obligations where Variation Margin is exchanged by both parties over the life of the swap. The use of Initial Margin, however, has largely remained a one-way obligation for end-users, primarily imposed by swap dealers as a cushion against residual credit risk that may exist even under a collateralized trading agreement. This over-collateralization is intentional; it is a market practice that developed based on the role swap dealers play in derivatives trades and their relative credit standing. However, any situation in which one party has delivered collateral in excess of the credit exposure borne by the other party represents additional risk in the event that the other party becomes insolvent. As recent events demonstrate, most notably the collapse of Lehman Brothers, this is not merely hypothetical risk. Steps can be taken to mitigate or eliminate these risks.          

CFTC Final Rules on Protection of Initial Margin for Uncleared Swaps
Statutory Background
Section 4(s)(l) of the Commodity Exchange Act (the “CEA”) requires that a Registered Entity (i) notify each end-user at the beginning of a swap transaction that the end-user has the right to require segregation of its Initial Margin (the “Notice Requirement”) and (ii) segregate the Initial Margin at the request of the end-user (the “Segregation Requirement”).

Notice Requirement
Section 23.701 of the Final Rules implements the Notice Requirement and requires that a Registered Entity, prior to the execution of each uncleared swap:

• Notify an appropriate officer of the end-user that it has the right to require that any Initial Margin it provides in connection with such swap be segregated in accordance with sections 23.702 and 23.703 of the Final Rules; [3]

• Identify one or more custodians, one of which must be a creditworthy non-affiliate and each of which must be a legal entity independent of both parties to the swap, as acceptable depositories for segregated Initial Margin; [4] and

• Provide information regarding the price of segregation for each such custodian to the extent the Registered Entity has such information.

This notification must be provided by a Registered Entity to its end-users at least once per calendar year (unless the Registered Entity does not enter into a swap with the end-user during a given calendar year). An end-user may, in its discretion, change its election to require or not to require segregation of Initial Margin by delivering written notice to the Registered Entity, which changed election would apply to all swaps entered into between the parties after such notice is delivered.

Segregation Requirement
If an end-user elects to segregate its Initial Margin, section 23.702 of the Final Rules requires that:

• The custodian holding the Initial Margin segregated pursuant to such an election must be a legal entity “independent” of both the Registered Entity and the end-user; and
• Initial Margin segregated pursuant to such an election must be held in an account segregated for and on behalf of the end-user and designated as such (which account may, if both parties agree, also hold Variation Margin).

The CFTC has indicated that segregation should become effective upon election, not upon completion of custodial documentation. [5]

Section 23.702 of the Final Rules further requires that any agreement for the segregation of margin must (i) be in writing, (ii) include the custodian as a party, and (iii) provide that:

• Any withdrawal of such margin other than pursuant to a “turnover of control” of such margin (described below) may be made only by agreement of both parties and notification thereof must be provided immediately to the non-withdrawing party; or

• The custodian will turn over control of such margin to the end-user or to the Registered Entity, promptly upon presentation to it of a statement in writing, made under oath or under penalty of perjury as specified in 28 U.S.C. 1746, by an authorized representative of either such party, stating that this party is entitled to such control pursuant to an agreement between the parties (and the other party must be immediately notified of such turnover). [6]

Investment of Segregated Margin
Section 23.703(a) provides that margin for uncleared swaps that is segregated pursuant to an election under section 23.701 may only be invested consistent with CFTC regulation 1.25. [7] Subject to the foregoing, the parties may enter into any written commercial arrangement, regarding the investment of such margin and the allocation of resulting gains and losses. The CFTC acknowledges that this standard may lead to lower investment returns, but it stresses the importance of protecting collateral and mitigating the systemic risk that could result from the loss of access to such collateral.

The CFTC also provides helpful clarification where the parties to an uncleared swap have agreed to segregate both Initial Margin and Variation Margin. In such cases, margin amounts may be commingled and held in the same account, but to the extent that the parties agree to commingle segregated Initial Margin and Variation Margin, the requirements set forth in sections 23.700 through 23.704, including the investment restrictions in section 23.703(a) (as described in this alert), would apply to all margin held in such account.

Requirements for Non-Segregated Margin
Section 4s(l)(4) of the CEA requires that if an end-user chooses not to require segregation, the Registered Entity must report to the end-user, on a quarterly basis, that the back-office procedures of the Registered Entity relating to margin and collateral requirements are in compliance with the agreement of the parties. [8]

Section 23.704 implements this statutory provision by requiring the chief compliance officer of a Registered Entity to report to each end-user that chooses not to require segregation of Initial Margin pursuant to section 23.701(a), no later than the 15th business day of each calendar quarter, on whether the Registered Entity’s back-office procedures relating to margin and collateral requirements were, at any point during the previous quarter, not in compliance with the agreement of the parties. This obligation applies with respect to each Registered Entity no earlier than the 90th calendar day after the date on which the first swap is transacted between the end-user and the Registered Entity.

The CFTC acknowledges in the release that end-users may choose to segregate in some lesser manner than that contemplated by section 23.702, while others may choose not to segregate at all. In either case, where an end-user to an uncleared swap does not elect to require segregation of Initial Margin in accordance with section 23.702, the Registered Entity must comply with this reporting requirement.

Compliance Dates
The Final Rules were published in the Federal Register on November 6, 2013, and became effective on January 6, 2014 (the “Effective Date”). The specific compliance dates are the following:

• Where no agreement (e.g., an ISDA Master Agreement) exists between the Registered Entity and the end-user concerning uncleared swaps on the Effective Date (i.e., for transactions involving “new counterparties”), the Registered Entity must be in compliance with the Final Rules with respect to that swap no later than May 5, 2014; and

• Where an agreement already exists between the Registered Entity and the end-user on the Effective Date (i.e., for transactions involving “existing counterparties”), the Registered Entity under an uncleared swap must be in compliance with the Final Rules with respect to that swap no later than November 3, 2014.

It should be noted, however, that the Final Rules do not apply to swaps entered into prior to the Effective Date. End-users who wish to avoid potential trading disruptions should be prepared to respond to notices from Registered Entities prior to the applicable compliance date.

ISDA Market Advisory and CFTC IM Segregation Right Notice
On March 13, 2013, the International Swaps and Derivatives Association (“ISDA”) released an advisory note to increase awareness of upcoming dates and obligations under the Final Rules. [9] The advisory note includes a form that market participants can use to send the required collateral management contact information to Registered Entities and reminds parties of their obligations under the Final Rules, notably the need to establish compliant segregation arrangements (or to modify existing arrangements).

On March 27, 2014, ISDA published the “CFTC IM Segregation Right Notice” and accompanying “Frequently Asked Questions.” [10] These documents are intended to assist market participants in implementing the Final Rules, notably the requirement for Registered Entities to notify end-users of their right to require segregation of Initial Margin for uncleared swaps.

ISDA and Markit are providing additional tools on ISDA Amend to assist market participants in designating collateral management contact information, delivering/receiving the relevant notices regarding the right to Initial Margin segregation, confirming receipt of such notices, and making elections regarding whether to segregate Initial Margin. The ISDA Amend tool for designating and delivering collateral management contact information to Registered Entities is currently available for use, while the functionality for delivery/receipt of the relevant notices regarding the right to Initial Margin segregation, confirmations of receipt and communication of segregation elections are in development and are expected to be available in late April 2014. These tools will be available at no cost to non-dealer market participants. 

Practical Considerations for the End-User
Whether as a result of the credit quality of the end-user, the type of account or vehicle entering into the swap, the type of underlying exposure being taken, or the volatility of the swap, providing excess collateral to Registered Entities exposes end-users to additional risks.

Risk to End-Users Posting Initial Margin
While a swap dealer that imposes Initial Margin will benefit from the resulting buffer of additional collateral, the end-user assumes additional risk of loss in the event the swap dealer becomes insolvent.

In a swap dealer insolvency, if an end-user delivered Initial Margin directly to the swap dealer and the swap dealer either rehypothecated the margin or commingled the margin with its own assets, the end-user would have a general unsecured claim for the recovery of such margin and would be entitled to a pro rata distribution along with all other general unsecured creditors. This type of claim ranks behind other creditor claims of higher priority, and thus in many insolvencies general unsecured creditors get paid less than 100 percent of their claim amount. This was the case in the Lehman Brothers insolvency. End-users to swaps with a Lehman Brothers entity where Initial Margin was not segregated or afforded any client asset protections were exposed to losses because, following Lehman’s bankruptcy filing, claims for the return of cash and securities posted to meet Initial Margin requirements were treated as general unsecured claims on the debtor’s estate. 

Should I Elect to Segregate Initial Margin?
There are a variety of factors to consider that add to the complexity of the question; however, there is little doubt that third-party custodial segregation of Initial Margin is the safest arrangement for the end-user.  Despite that, there are some disadvantages.

Cost of Segregation
As a practical matter, the cost of segregation will likely include (i) the custodian’s fees, and (ii) higher transaction fees or charges imposed by the swap dealer resulting from its inability to re-use the margin (since rehypothecation by the swap dealer under a third-party custodial arrangement is generally not possible). In many cases, the costs associated with negotiating a segregation arrangement may render the swap prohibitively expensive for the end-user. The end-user will need to determine whether the benefits to it of such an arrangement justify the higher transaction costs.

Segregation Arrangements (i.e., tri-party agreements)
The Final Rules require the third-party custodial relationship to be documented in a written agreement. The segregated margin can be released to one party or the other either (i) upon the agreement of both the end-user and the Registered Entity, or (ii) upon a written statement by one party that such party is entitled to control of the Initial Margin under an agreement between the end-user and the Registered Entity. The statement must be signed by the party’s authorized representative “under penalty of perjury.” The requirement that the written statement be “under penalty of perjury” is an attempt to balance the need of the parties to obtain the margin quickly in some circumstances (for example, in the event of a default) and the need to protect against improper requests to gain access to the margin.

Determining the circumstances under which the custodian may comply with an end-user request for return of margin will likely be a point of contention between the Registered Entity and the end-user. The end-user should not assume that its margin will be returned as soon as the end-user asserts that the Registered Entity has defaulted. If the Registered Entity challenges the end-user’s default determination, it could be some time before the issue is resolved. During that time, the customer may not have access to its margin.

ISDA has long tried to harmonize practices in the swaps market by establishing a set of “best collateral practices” intended to mitigate risks inherent in the collateral management process and also to set expectations and standards for new entrants to the swaps market. [11] In this publication, ISDA promotes the use of “standardized industry documentation” to “promote market convergence towards common standards”. [12] In recognition of this principle, ISDA published the ISDA 2013 Account Control Agreement (the “ISDA ACA”) to facilitate the negotiation process of contractual arrangements that provide for segregation of Initial Margin with a third party custodian. [13] Similar to other tri-party account control agreements, the ISDA ACA is a three-way contract between the custodian, an end-user, and presumably a swap dealer, and it provides that the custodian will hold and release Initial Margin to a requesting party based on pre-defined conditions. The ISDA ACA has a similar structure to the ISDA Master Agreement. It aims to streamline negotiations for segregation arrangements by offering a standardized agreement with an accompanying annex containing suggested optional provisions that can be tailored as appropriate. While the ISDA ACA complies with regulatory requirements, the provisions and/or annexes are not necessary or appropriate under all circumstances. The author was involved with ISDA in the development of predecessor terms and provisions addressing the segregation of margin and has helped market participants address these and similar issues.

Initial Margin versus Variation Margin
As a general matter, segregation is easier to implement and manage with respect to Initial Margin than Variation Margin. Variation Margin constantly changes and often flows back and forth between the parties of a daily basis, making it administratively difficult to segregate. However, the Final Rules do not prohibit the segregation of Variation Margin, and parties may want to consider whether the arrangement should apply to all margin or only Initial Margin. This approach can be more cost-effective yet still protect Initial Margin.

Custodian Risk
While somewhat outside the scope of the Final Rules, segregation arrangements are also subject to the risk of a custodian default. Entities providing such services are generally subject to special rules or structure their business models in such a way as to minimize the risk of their default from the perspective of parties entrusting assets to their care. As noted in footnote 4, the Final Rules do not prohibit affiliates of a Registered Entity from serving as custodian. There is a risk, however, that affiliated parties will experience contemporaneous insolvency, even if they are independently run and have different business models and/or regulatory oversight regimes. End-users may want to consider conducting a complete risk assessment before selecting a custodian to hold segregated margin.

Timing
New end-users may want to consider whether there will be sufficient time to provide Registered Entities with their collateral management contact information and segregation election prior to the May 5, 2014 compliance date. Despite the availability of tools on ISDA Amend, the full suite of tools is still in development and a new end-user may be instructed by a Registered Entity to deliver its confirmation and election directly to such Registered Entity (rather than through ISDA Amend) in order to avoid any trade disruptions on or after May 5, 2014.

Conclusion
Uncleared swaps are and will be in demand by a variety of corporations, energy companies, investment managers, pension funds, governments, and financial institutions to hedge their risks. The heads of state of the G-20 nations have called for regulators to devise proposals to improve margin arrangements in the uncleared swaps market and the global regulatory community has responded. Although the use of Initial Margin is an essential tool for systemic resilience, the Lehman experience has led to an increased awareness of the risks associated with posting Initial Margin. End-users contemplating collateral arrangements containing Initial Margin terms may want to carefully evaluate the risks, costs, limitations, and effectiveness of any Initial Margin holding structure.