On June 25, 2020, the Board of Governors of the Federal Reserve (the "Federal Reserve"), the Farm Credit Administration (the "FCA"), the Federal Deposit Insurance Corporation (the "FDIC"), the Federal Housing Finance Agency (the "FHFA"), and the Office of the Comptroller of the Currency (the "OCC" and, together with the Federal Reserve, FCA, FDIC, and FHFA, the "Prudential Regulators") approved final amendments (the "Final Rule")1 to their margin requirements for non-cleared swaps and security-based swaps (together, "swaps") for swap dealers, security-based swap dealers, major swap participants and major security-based swap participants regulated by the Prudential Regulators ("Swap Entities") (the "Margin Rules"). The Final Rule (1) mostly eliminates initial margin ("IM") requirements for swaps between affiliates; (2) preserves legacy status for swaps that are amended to replace certain interest rate provisions or due to technical amendments, notional reductions, or portfolio compression exercises; (3) clarifies the time at which IM trading documentation must be in place; (4) finalizes, as initially adopted, the interim final rule dealing with Brexit-related issues; and (5) adds a sixth compliance phase for IM requirements.2 The Final Rule will take effect 60 days after publication in the Federal Register.

The Prudential Regulators also published an interim final rule (the "Interim Final Rule")3 providing Swap Entities with an additional year to comply with the IM requirements for counterparties in phases 5 and 6. The Interim Final Rule will take effect 61 days after publication in the Federal Register.

This memorandum provides an overview of the Final Rule and the Interim Final Rule. Appendix A includes a blackline showing the amendments to the Margin Rules.

Inter-Affiliate Swaps

  • Background. Currently, the Margin Rules require a Swap Entity (often a bank) to collect IM on non-cleared swaps with an affiliate counterparty that is a Swap Entity or financial end user with a material swaps exposure (a "covered affiliate counterparty" and such swaps, "covered inter-affiliate swaps"), subject to a $20 million threshold. Any such IM must be segregated at a custodian, which for noncash IM may be the Swap Entity or an affiliate. Based on concerns regarding the impact this requirement has on centralized risk management by Swap Entities, among other considerations, in 2019 the Prudential Regulators proposed to eliminate this inter-affiliate IM collection requirement.
  • Exemption. The Final Rule exempts a Swap Entity from collecting IM on covered inter-affiliate swaps, subject to an aggregate limit calibrated at 15% of tier 1 capital.
    • Each Swap Entity must calculate, every business day, an IM collection amount for each covered affiliate counterparty.
    • The Swap Entity need not collect IM from any covered affiliate counterparty if the aggregate calculated amount does not exceed 15% of the Swap Entity's tier 1 capital.
    • If the aggregate calculated IM collection amount exceeds 15% percent of the Swap Entity's tier 1 capital, then the Swap Entity must collect IM (under the Margin Rules) for each new, additional covered inter-affiliate swap, from the day after execution and continuing on a daily basis, until the earlier of the (a) termination date of the covered inter-affiliate swap or (b) business day on which the aggregate calculated IM collection amount falls below 15% percent of the Swap Entity's tier 1 capital.
    • A Swap Entity will not be required to begin collecting IM on its portfolio of covered inter-affiliate swaps that were executed before the business day on which it exceeds the 15% tier 1 limit.
The Prudential Regulators observe that Swap Entities have collected inter-affiliate IM at levels that do not exceed the 15% tier 1 capital limit. Accordingly, the Final Rule does not address what approach a Swap Entity should take if it exceeds this limit as of the effectiveness of the Final Rule (e.g., to what extent could such a Swap Entity release previously collected IM falling below the limit?).
  • Segregation Requirements. Consistent with existing rules, when a Swap Entity collects IM from covered affiliate counterparties, the IM must be segregated in accordance with the Margin Rules, except that the Swap Entity or an affiliate may act as custodian for noncash IM.
  • Treatment of Subsidiaries. Covered inter-affiliate swaps by any subsidiary of the Swap Entity must be counted as swaps by the parent Swap Entity, and compliance may be undertaken at the parent Swap Entity level (including if the subsidiary is itself a Swap Entity, in which case the subsidiary is exempted from inter-affiliate IM collection obligations).
  • Credit Risk Backstop. Notwithstanding the exemption, every Swap Entity is required to consider its relationships with all its affiliated counterparties (including covered affiliate counterparties) and collect IM at such times and in such forms and such amounts (if any) that the Swap Entity determines appropriately addresses the credit risk posed by the counterparty and the risks of its swaps with the counterparty.
The preamble to the Final Rule states this more definitively: "[T]he agencies do not assess inter-affiliate swaps to be risk-free, and there can still be circumstances in which the agencies would expect a [Swap Entity] to incorporate [IM] as well as variation margin into its risk management for exposures to a particular affiliate or particular swaps."4
  • Broader Exemption for Certain Foreign Entities. Certain non-U.S. Swap Entities— (a) entities organized outside the U.S. that are not subsidiaries or branches of offices of U.S.-organized entities, (b) U.S. branches and agencies of foreign banks, and (c) foreign subsidiaries of a depository institution, Edge corporation, or agreement corporation—will be exempted from inter-affiliate IM collection requirements entirely, even above the 15% tier 1 threshold, so long as the non-U.S. Swap Entity's obligations under its covered inter-affiliate swaps are not guaranteed by a U.S.-organized entity (other than a U.S. branch or agency of a foreign bank), U.S. resident natural person, or branch or office of a U.S.-organized entity.
However, if the non-U.S. Swap Entity is a subsidiary of a U.S. Swap Entity, then its covered inter-affiliate swaps must be counted as swaps by the parent Swap Entity, as noted above.
  • Posting of IM. No IM need be posted by a Swap Entity to a covered affiliate counterparty.
  • Variation Margin. Under the Final Rule, Swap Entities will continue to be required to exchange variation margin ("VM") with covered affiliate counterparties.
  • Affiliate and Subsidiary Definitions. For purposes of the Final Rule:
    • An affiliate includes a subsidiary of the Swap Entity (i.e., the Swap Entity must calculate IM requirements from a subsidiary in its aggregate daily calculation, but where the subsidiary is itself a Swap Entity there is no double-counting of non-cleared swaps with the parent Swap Entity).
    • An affiliate and a subsidiary are determined not only by the consolidation provisions in the original Margin Rules, but also by a "control" test which appears to be the Federal Reserve's concept of control under Regulation Y.
  • Interaction with Sections 23A/23B and Regulation W. Swaps between a bank and its affiliates continue to be subject to Sections 23A and 23B of the Federal Reserve Act and the Federal Reserve's Regulation W.5 The Dodd-Frank Act had amended Section 23A to treat a derivatives transaction between a bank and its affiliate as a covered transaction to the extent it causes the bank to have credit exposure to the affiliate, but the term "credit exposure" was not defined. In addition, the Margin Rules' imposition of two-way IM requirements on swaps between a bank Swap Entity and an unaffiliated Swap Entity or financial end user with material swaps exposure had raised questions regarding how to interpret Section 23B's "market terms" requirement in connection with swaps between a bank and its affiliate. The Federal Reserve's version of the preamble to the Final Rule provides the following guidance regarding those topics:
  • Under Section 23A, bank-affiliate derivatives generally can be valued at the bank's current exposure to the affiliate. In other words, a bank must collect 23A-compliant VM from its affiliates to cover its current exposure (essentially, VM) on bank-affiliate derivatives, but generally is not required to collect IM to cover the bank's potential future exposure on the transactions.
    • For purposes of Section 23B, the Federal Reserve would "in many cases" find it reasonable to conclude that a bank-affiliate swap with no IM requirement is at least as favorable to the bank as a comparable bank-non-affiliate swap with two-way IM requirements. The reasonableness of this opinion is based on the Federal Reserve's belief that two counterparties in the market often give each other roughly equivalent value in IM. Therefore, "[i]n the Board's view, situations where the bank and affiliate each agree not to require an equivalent exchange of [IM] . . . will generally create a set of contractual terms that is roughly equally favorable to the bank as a two-way [IM] regime."6
    • However, the Federal Reserve warns that some cases of bank-affiliate swap arrangements without IM could raise issues under Section 23B, and banks should determine whether certain factors should result in the receipt of IM under Section 23B, including the relative creditworthiness of the bank vs. the affiliate, whether the bank-affiliate swap portfolio is more likely to create potential future exposure of the bank to the affiliate or vice versa, and whether or not the affiliate requires IM from the bank under the swap arrangement.
As a result of the Federal Reserve's interpretation of Section 23B, banks will need to adopt policies, procedures, and controls that address these considerations for when a bank may need, under Section 23B, to collect IM from its affiliates.

Amendments to Legacy Swaps to Replace Certain Interest Rate Provisions

  • Background. The Margin Rules do not apply to swaps entered into prior their compliance dates, i.e., legacy swaps. When they originally adopted the Margin Rules, the Prudential Regulators declined to adopt guidance classifying certain types of amended or novated swaps as legacy swaps. As a result, there have been significant questions regarding what types of amendments to legacy swaps trigger application of the Margin Rules.
  • Safe Harbor. Amendments to all categories of non-cleared legacy swaps that are made solely to accommodate the replacement of (1) an interbank offered rate ("IBOR"), (2) any other interest rate that a Swap Entity reasonably expects to be replaced or discontinued or reasonably determines has lost its relevance as a reliable benchmark due to a significant impairment, or (3) any other interest rate that succeeds a rate referenced in (1) or (2) will not cause a loss of legacy status.
One commenter requested the relief be extended to cover amendments made solely to accommodate the replacement of any reference instrument, such as iTraxx, reasonably expected to be discontinued or reasonably determined to have lost its relevance as a reliable benchmark due to a significant impairment. The Prudential Regulators declined to make this change, as there is no current expectation or indication that any major non-interest rate reference instrument is expected to be discontinued. However, they noted that they may reconsider their position in the future if any expectation of discontinuation arises. In addition, the Prudential Regulators departed from the proposed rule to allow legacy swaps to be amended to reflect changes to the discount interest rate used by some central counterparties.
  • Any new intermediate or permanent interest rate does not have to be viewed by the market as a "successor" to the IBOR or other discontinued rate that is being replaced. Instead, the counterparties to the swap contract simply must agree on the appropriate replacement interest rate.
  • Under the Final Rule, these amendments may be made to the legacy swap by adherence to a protocol, other type of amendment of an existing contract or confirmation, or execution of a new contract or confirmation in replacement of and immediately upon termination of an existing contract.
  • Amendments to accommodate replacement of an interest rate may also be effectuated through portfolio compression between or among Swap Entities and their counterparties driven by the sole purpose of replacing an interest rate.
The Prudential Regulators rejected commenters request to extend relief from the Margin Rules' IM and VM requirements to non-legacy swaps designed to transition an existing swap, or entered into solely for managing the transition, away from IBORs. Commenters suggested this expansion would facilitate the use of basis swaps to offset IBOR exposure from legacy swaps against new exposure to a risk-free rate. However, the Prudential Regulators did not think this approach would be effective in resolving the issue of a discontinued interest rate, as Swap Entities with basis swaps would still bear the risk of the relevant interest rate being discontinued.
  • Follow-on Amendments. The Final Rule allows "follow-on" amendments that accommodate replacement of an interest rate to be made to legacy swaps without causing a loss of legacy status.
    • These amendments may incorporate spreads or other adjustments to the replacement interest rate and make other necessary technical changes to operationalize the determination of payments or other exchanges of economic value using the replacement interest rate, including changes to determination dates, calculation agents, and payment dates.
    • These amendments may not extend the swap's maturity or increase the swap's total effective notional amount more than what is necessary to accommodate the differences between market conventions for an outgoing interest rate and its replacement. Swaps resulting from a portfolio compression are subject to a similar limitation.

In the proposed rule, the safe harbor for legacy swaps would have been unavailable if the amendments extended the maturity or increased the total effective notional amount of the swap, regardless of the reason for the change. Commenters raised concerns with this restriction since market conventions are not yet well established or expected with respect to the transition away from IBORs. Based on these comments, the Prudential Regulators modified the Final Rule to allow for extensions of maturity or increases in total effective notional amounts as necessary to accommodate the differences between market conventions for an outgoing interest rate and its replacement.

Market conventions could include changes in day count conventions, settlement date, or final payment date.

The Prudential Regulators declined, however, to permit an extension of the remaining maturity of a legacy swap for liquidity or similar reasons (e.g., to match a benchmark tenor), stating that it could lead to inappropriate extensions or evasion of the Margin Rules.

  • Exemptions for Commercial and Cooperative End Users. One commenter requested clarification on the treatment of non-cleared swaps that are exempt from the Margin Rules under the commercial and cooperative end-user exemption, if such swaps are amended to accommodate changes to referenced benchmark interest rates.
    • The Prudential Regulators clarified that commercial and cooperative end-user swaps will remain exempt regardless of changes to referenced benchmark interest rates if the swaps are effectuated under the terms of U.S. Commodity Futures Trading Commission ("CFTC") Letter No. 19-287 or CFTC Letter 19-26.8

CFTC Letters No. 19-28 and No. 19-26 provide relief from the CFTC's mandatory clearing and margin requirements for non-cleared swaps where the counterparties previously relied on the end-user exemptions in the Commodity Exchange Act and applicable CFTC regulations.

In order to qualify for no-action relief under these letters, the swap must be (1) amended solely to replace, or accommodate the replacement of, an impaired reference rate and (2) amended prior to December 31, 2021, such that it again qualifies for the end-user exemptions.

Amendments to Legacy Swaps for Technical or Risk-Reduction Reasons

  • Technical Changes. The Final Rule recognizes the legacy status of a non-cleared swap that has been amended to reflect technical changes, such as addresses, the identities of parties for delivery of formal notices, and other administrative or operational provisions.
    • However, these changes may not alter the non-cleared swap's underlying asset or reference, the remaining maturity, or the total effective notional amount.
Based on comments received, the Prudential Regulators clarified that the Final Rule aligns with CFTC Letter No. 19-13.9 In this letter, the CFTC took a no-action position on legacy swaps that are amended, "provided that no term is amended that would affect the economic obligations of the parties or the valuation" of the swap, subject to certain conditions.10
  • Reduction in Notional Amount. The Final Rule recognizes the legacy status of a non-cleared swap that has been amended solely to reduce its notional amount.
    • However, all payment obligations attached to the total effective notional amount being eliminated as a result of the amendment must be either fully terminated or fully novated to a third party, who complies with applicable margin rules for the novated portion upon the transfer.
  • Portfolio Compression Exercises. The Final Rule recognizes the legacy status of non-cleared swaps that have been amended to reduce risk or remain risk-neutral through portfolio compression between or among Swap Entities and their counterparties.
    • However, the non-cleared swaps resulting from the portfolio compression must not (1) exceed the sum of the total effective notional amounts of all of the swaps that were submitted to the compression exercise that had the same or longer remaining maturity as the resulting swap, or (2) exceed the longest remaining maturity of all swaps submitted to the compression exercise.
The Prudential Regulators modified the Final Rule to separate portfolio compressions for the purposes of replacing an interest rate (as discussed above) from those for other risk-reducing or risk-neutral purposes.

IM Documentation Requirements

  • The Final Rule specifies that IM trading documentation is not required to be in place prior to the time that IM is required to be collected or posted under the Margin Rules.
  • The Prudential Regulators also reaffirmed their statement in the preamble to the rule proposal that custody agreements are required to be in place only (1) after IM is required to be collected or posted pursuant to the Margin Rules, or (2) when IM is posted by a Swap Entity beyond an amount required by the Margin Rules.

Brexit Interim Final Rule

  • The Prudential Regulators issued an interim final rule, which became effective on March 19, 2019, to provide certainty for Swap Entities as they prepared for Brexit.11 Specifically, the interim final rule provided a Swap Entity with the ability to continue to service its cross-border clients if the U.K. withdrew from the E.U. without a Withdrawal Agreement.
    • A Withdrawal Agreement between the U.K. and E.U. was ratified in January 2020.12
The sole commenter on the interim final rule requested that swaps with a flip clause be excluded. As this was an issue outside of the scope of the rule, the Prudential Regulators finalized the rule as adopted.

Additional Compliance Date for IM Requirements

  • " The Final Rule extends compliance with IM requirements to September 1, 2021 for counterparties with an average daily aggregate notional amount ("AANA") of non-cleared swaps from $8 billion to $50 billion.
Commenters noted calculation of the AANA for these counterparties would be based on June, July, and August of the previous calendar year (i.e., 2020). This is inconsistent with the Basel Committee on Banking Supervision and International Organization of Securities Commissions ("BCBS/IOSCO") Framework, which calculates the AANA based on March, April, and May of the same year. However, the Prudential Regulators declined to make an aligning change.

Interim Final Rule for IM Requirements

  • The Prudential Regulators adopted an interim final rule extending by one year the implementation deadlines for IM requirements for phases 5 (for counterparties with AANA between $50 billion and $750 billion) and 6 (for counterparties with an AANA between $8 billion and $50 billion) due to the COVID-19 pandemic.13
    • The effective date for phase 5 is now September 1, 2021, and the effective date for phase 6 is now September 1, 2022.
    • However, Swap Entities and their counterparties may voluntarily comply with IM requirements prior to these mandatory compliance dates.
  • This extension aligns with that granted by BCBS/IOSCO for its IM implementation schedule and rule amendments and proposals from the CFTC.14

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Footnotes

1. Margin and Capital Requirements for Covered Swap Entities, Docket No. OCC-2019-0023/RIN: 1557-AE69, Docket No. R-1682/RIN: 7100-AF62, RIN: 3064-AF08, RIN: 3052-AD38, RIN: 2590-AB02.

2. Margin and Capital Requirements for Covered Swap Entities, 84 Fed. Reg. 9940 (Mar. 19, 2019).

3. Margin and Capital Requirements for Covered Swap Entities, Docket No. OCC-2020-0027/RIN: 1557-AE98, Docket No. R-1721/RIN: 7100-AF92, RIN: 3064-AF55, RIN: 3052-AD34, RIN: 2590-AB03.

4. Final Rule at 40 (emphasis added)

5. 12 U.S.C. § 371c (Section 23A); 12 U.S.C. § 371c-1 (Section 23B); 12 CFR pt. 223 (Regulation W).

6. Final Rule at 39-40.

7. CFTC Letter No. 19-28 (Dec. 17, 2019).

8. CFTC Letter No. 19-26 (Dec. 17, 2019).

9. CFTC Letter No. 19-13 (June 6, 2019).

10. Id. at 8.

The conditions include:

1. The records of the legacy swap that exist in the trading and/or recordkeeping systems of the Swap Entity are amended solely to reflect the reduced notional amount of the legacy swap;

2. The stated portion of the legacy swap that is terminated or novated by such Swap Entity is fully terminated between the Swap Entity and its original counterparty, apart from the stated portion that is the stub; and

3. All other material terms (as such term is defined in CFTC Regulation 23.500(g)) of the stub remain the same as the terms of the legacy swap.

11. Margin and Capital Requirements for Covered Swap Entities, 84 Fed. Reg. 9940 (Mar. 19, 2019).

12. See European Council Press Release "Brexit: Council adopts decision to conclude the

withdraw agreement" (Jan. 30, 2020), available at

https://www.consilium.europa.eu/en/press/press-releases/2020/01/30/brexit-council-adopts-decision-to-conclude-the-withdrawal-agreement/.

13. Margin and Capital Requirements for Covered Swap Entities, Docket No. OCC-2020-0027/RIN: 1557-AE98, Docket No. R-1721/RIN: 7100-AF92, RIN: 3064-AF55, RIN: 3052-AD34, RIN: 2590-AB03.

14. Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 85 Fed. Reg. 19878 (Apr. 9, 2020) (final rule to add Phase 6 to compliance schedule for CFTC margin rules); Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, RIN: 3038-[] (interim final rule to defer compliance date of Phase 5 of CFTC margin rules to September 1, 2021); Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, RIN: 3038-AE89 (proposed rule to defer compliance date of Phase 6 of CFTC margin rules to September 1, 2022).

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