Swap-margin proposal spares nonfinancial counterparties but vagaries remain.
Delighting corporate end-users of swaps, the prudential regulators re-proposed margin rules for uncleared swaps that largely maintain current practice for nonfinancial companies hedging risk, although at least one significant ambiguity remains.
Sources stressed that unpleasant details could emerge after scrutinizing the 200-page proposal, which was unveiled by the five prudential banking regulators Wednesday morning. Plus, final rules can vary significantly from proposals. Nevertheless, the re-proposal quite clearly states that it takes a different approach to nonfinancial end-users than the original proposal issued in 2011. It required swap dealers to establish exposure thresholds with their non-financial counterparties that, when exceeded, required margin to be posted.
“Like the 2011 proposal, this proposal follows the statutory framework and proposes a risk-based approach to imposing margin requirements,” the proposal says. “Unlike the 2011 proposal, this proposal does not require that the covered swap entity determine a specific, numerical threshold for each nonfinancial end-user counterparty.”
The Coalition for Derivative End Users has argued against nonfinancial end user margin requirements practically since the original proposal emerged. It was concerned the margin requirement would return in the re-proposal because the prudential regulators had stated on several occasions that they interpreted the Dodd Frank Act as requiring them to impose margin on all swap users, and they didn’t have the authority to exempt one class of users. And, given they had made no attempt to walk back those statements, market participants concluded that Congress would have to fix the problem.
Fed officials quickly dispelled that notion early on in a Fed meeting Wednesday morning in which the board members approved the re-proposal.
Sean Campbell, deputy associate director at the Federal Reserve, said that a swap dealer would only have to collect margin from a corporate client if it determines doing so appropriately addresses the risk posed by the counterparty—essentially, the current approach.
“Given the limited amount fo systemic risk in a swap transaction between swap [dealers] and commercial end-users, staff believes this treatment of nonfinancial end-users is appropriate and consistent with the statutory requirement that all non-cleared swaps of a swap entity be subject to margin requirements, but that the margin requirements be risk based,” Campbell said.
The re-proposal essentially shifts the responsibility of whether to impose margin entirely to the swap dealer counterparties.
“It seemed as if regulators had walked themselves into a corner, but they found a way to get out of it in the re-proposal,” said Luke Zubrod, director of risk and regulatory advisory at Chatham Financial.
One area that remains ambiguous in the re-proposal concerns treasury centers, which are entities established by corporates to net derivative exposures across the company before approaching Wall Street in search of a hedge.
“We’re very encouraged by the re-proposal, but from what we’ve experienced in the last four years the devil is in the details,” said Tom Deas, treasurer of FMC Corp. and the International Group of Treasury Associations’ chairman. “While regulators appear to have exempted nonfinancial end-users, there’s still uncertainty around that definition.”
Specifically, Mr. Deas said, it remains unclear how treasury centers, increasingly common among multinational companies, will be classified.
“If the parent company is a manufacturer that clearly is a nonfinancial end user of swaps, then it’s gotten significant relief. But if its derivative activity is focused in one of these treasury-center units, it’s still got some issues to work out.”
In addition to discussing the nonfinancial end user view on margin and treasury centers with the regulators, the Coalition has been pursuing a bill on Capitol Hill to exempt nonfinancial end-users from margin requirements and another to ensure treasury centers are exempted as well. The margin bill has passed the full house this Congress and awaits Senate approval. The treasury-center bill passed the full house in the previous Congress and this Congress has passed key committees and is now awaiting to get on the calendar for a full House vote.
Michael Bopp, co-chair of the public policy practice group at Gibson, Dunn & Crutcher, said the greater challenge rests on the Senate side. Mr. Bopp, who has played a key role in creating and running the Coalition, said ideally the Senate Committee on Agriculture, Nutrition and Forestry will approve a bill reauthorizing the Commodity Futures Trading Commission when Congress returns next week for a two-week session. If so, it will include the treasury center bill and perhaps the margin bill.
“If the committee is not able to make significant progress in those two weeks, the CFTC reauthorization bill will not be a viable option for us, and we’ll be moving toward getting the bills enacted as stand-alone measures,” Mr. Bopp said, adding that approach would require unanimous consent from all members of the Senate.
Mr. Bopp said that the Coalition is still determining whether to pursue the margin bill, given the regulator’s re-proposal. He noted that the regulators directly addressed comments the Coalition made, and “we’re very appreciative of what the regulators did,” Mr. Bopp said. Nevertheless, he said, the Dodd-Frank Act’s language does state margin requirements should be placed on all swaps, so a margin exemption would be more secure if it were carved into the statute. “The Fed can always change its mind; if we pass legislation is permanent,” Mr. Bopp said
The coalition will definitely continue pursuing the bill affecting treasury centers since, Mr. Bopp said, adding statutory clarification is needed because there’s “no language in Dodd-Frank that addresses treasury centers as used by end-users.”
The treasury center issue will almost certainly draw suggestions from market participants submitting comments on the proposal—due 60 days after publication in the Federal Register—and it could be addressed in a final rule. Mr. Zubrod said it’s likely the issue will be addressed by both regulation and legislation. In terms of regulation, the prudential regulators could reference no-action relief granted by the CFTC, which ensures regulatory staff wouldn’t prosecute market participants whose treasury centers do not post margin.
“No-action relief doesn’t actually change the rule, so it might be a stretch to reference this, although it’s theoretically possible,” Mr. Zubrod said, adding that an additional problem is the CFTC’s no-action relief was highly conditional “and so it’s not clear whether it would encompass everyone it should.”
Besides its treatment of nonfinancial swap end-users, the re-proposal makes several changes from the original version. For example, it sets minimum amounts of initial margin swap dealers must collect and post to dealer and financial end user counterparties, such as asset managers and insurance companies. The original proposal only applied to collecting margin and didn’t set any specific posting requirement. The same holds true for variation margin.
In addition, for initial margin the list of eligible collateral has been broadened to include cash, gold, certain government bonds, corporate bonds and equities, all subject to minimum haircuts. In the case of variation margin, only cash is eligible collateral. The re-proposed rule also expands the 2011 proposal by requiring collateral to be segrated and held at a third-party custodian, and it prohibits the re-hypothecation of collected and posted initial margin, where a counterparty collects collateral from one swap transaction and then posts it to another. Variation margin, on the other hand, needn’t be segregated and it may be re-hypothecated.