2020-27736
Federal Register, Volume 86 Issue 2 (Tuesday, January 5, 2021)
[Federal Register Volume 86, Number 2 (Tuesday, January 5, 2021)]
[Rules and Regulations]
[Pages 229-250]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2020-27736]
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COMMODITY FUTURES TRADING COMMISSION
17 CFR Part 23
RIN 3038-AF05
Margin Requirements for Uncleared Swaps for Swap Dealers and
Major Swap Participants
AGENCY: Commodity Futures Trading Commission.
ACTION: Final rule.
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SUMMARY: The Commodity Futures Trading Commission (``Commission'' or
``CFTC'') is adopting amendments (``Final Rule'') to its margin
requirements for uncleared swaps for swap dealers (``SDs'') and major
swap participants (``MSPs'') for which there is not a prudential
regulator (``CFTC Margin Rule''). The Commission is amending the CFTC
Margin Rule to revise the calculation method for determining whether
certain entities come within the scope of its initial margin (``IM'')
requirements for uncleared swaps beginning in the last phase of the
phased compliance schedule, which starts on September 1, 2022, and the
timing for compliance with the IM requirements after the end of the
phased compliance schedule. These amendments align certain aspects of
the CFTC Margin Rule with the Basel Committee on Banking Supervision
and the International Organization of Securities Commissions' (``BSBS/
IOSCO'') Framework for margin requirements for non-centrally cleared
derivatives (``BCBS/IOSCO Framework''). The Commission is also amending
the CFTC Margin Rule to allow SDs and MSPs subject to the CFTC Margin
Rule to use the risk-based model calculation of IM of a counterparty
that is a CFTC-registered SD or MSP to determine the amount of IM to be
collected from the counterparty and to determine whether the IM
threshold amount for the exchange of IM has been exceeded such that
documentation concerning the collection, posting, and custody of IM
would be required.
DATES: This rule is effective February 4, 2021.
FOR FURTHER INFORMATION CONTACT: Joshua B. Sterling, Director, 202-418-
6056, [email protected]; Thomas J. Smith, Deputy Director, 202-418-
5495, [email protected]; Warren Gorlick, Associate Director, 202-418-
5195, [email protected]; or Carmen Moncada-Terry, Special Counsel, 202-
418-5795, [email protected], Market Participants Division,
Commodity Futures Trading Commission, Three Lafayette Centre, 1155 21st
Street NW, Washington, DC 20581.
SUPPLEMENTARY INFORMATION:
I. Background
Section 4s(e) of the Commodity Exchange Act (``CEA'' or ``Act'')
\1\ requires the Commission to adopt rules establishing minimum initial
and variation margin requirements for all swaps \2\ that are (i)
entered into by an SD or MSP for which there is no prudential regulator
\3\ (collectively, ``covered swap entities'' or ``CSEs'') \4\ and (ii)
not cleared by a registered derivatives clearing organization
(``uncleared swaps'').\5\ To offset the greater risk to the SD \6\ or
MSP \7\ and the financial system arising from the use of uncleared
swaps, these requirements must (i) help ensure the safety and soundness
of the SD or MSP and (ii) be appropriate for the risk associated with
the uncleared swaps held by the SD or MSP.\8\
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\1\ 7 U.S.C. 6s(e) (capital and margin requirements).
\2\ CEA section 1a(47), 7 U.S.C. 1a(47) (swap definition);
Regulation 1.3, 17 CFR 1.3 (further definition of a swap). A swap
includes, among other things, an interest rate swap, commodity swap,
credit default swap, and currency swap.
\3\ CEA section 1a(39), 7 U.S.C. 1a(39) (defining the term
``prudential regulator'' to include the Board of Governors of the
Federal Reserve System; the Office of the Comptroller of the
Currency; the Federal Deposit Insurance Corporation; the Farm Credit
Administration; and the Federal Housing Finance Agency). The
definition of prudential regulator further specifies the entities
for which these agencies act as prudential regulators. The
prudential regulators published final margin requirements in
November 2015. See generally Margin and Capital Requirements for
Covered Swap Entities, 80 FR 74840 (Nov. 30, 2015) (``Prudential
Margin Rule''). The Prudential Margin Rule is substantially similar
to the CFTC Margin Rule, including with respect to the CFTC's
phasing-in of margin requirements.
\4\ CEA section 4s(e)(1)(B), 7 U.S.C. 6s(e)(1)(B). SDs and MSPs
for which there is a prudential regulator must meet the margin
requirements for uncleared swaps established by the applicable
prudential regulator. CEA section 4s(e)(1)(A), 7 U.S.C. 6s(e)(1)(A).
\5\ CEA section 4s(e)(2)(B)(ii), 7 U.S.C. 6s(e)(2)(B)(ii). In
Regulation 23.151, the Commission further defined this statutory
language to mean all swaps that are not cleared by a registered
derivatives clearing organization or a derivatives clearing
organization that the Commission has exempted from registration as
provided under the CEA. 17 CFR 23.151.
\6\ CEA section 1a(49), 7 U.S.C. 1a(49) (swap dealer
definition); Regulation 1.3 (further definition of swap dealer).
\7\ CEA section 1a(32), 7 U.S.C. 1a(32) (major swap participant
definition); Regulation 1.3 (further definition of major swap
participant).
\8\ CEA section 4s(e)(3)(A), 7 U.S.C. 6s(e)(3)(A).
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Pursuant to its rulemaking authority under section 4s(e), the
Commission in 2016 promulgated Regulations 23.150 through 23.161,
namely the CFTC Margin Rule, which requires CSEs to
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collect and post IM \9\ and variation margin (``VM'') \10\ for
uncleared swaps.\11\ In administering the CFTC Margin Rule, the
Commission has identified matters, further described below, that may
pose challenges in the implementation of the IM requirements.
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\9\ IM or initial margin is the collateral (calculated as
provided by Regulation 23.154) that is collected or posted in
connection with one or more uncleared swaps pursuant to Regulation
23.152. IM is intended to secure potential future exposure following
default of a counterparty (i.e., adverse changes in the value of an
uncleared swap that may arise during the period of time when it is
being closed out). See CFTC Margin Rule, 81 FR at 683.
\10\ VM or variation margin, as defined in Regulation 23.151, is
the collateral provided by a party to its counterparty to meet the
performance of its obligations under one or more uncleared swaps
between the parties as a result of a change in the value of such
obligations since the trade was executed or the last time such
collateral was provided. 17 CFR 23.151.
\11\ See generally Margin Requirements for Uncleared Swaps for
Swap Dealers and Major Swap Participants, 81 FR 636 (Jan. 6, 2016).
The CFTC Margin Rule, which became effective April 1, 2016, is
codified in part 23 of the Commission's regulations. 17 CFR 23.150
through 23.159, 23.161. In May 2016, the Commission amended the CFTC
Margin Rule to add Regulation 23.160, 17 CFR 23.160, providing rules
on its cross-border application. See generally Margin Requirements
for Uncleared Swaps for Swap Dealers and Major Swap Participants--
Cross-Border Application of the Margin Requirements, 81 FR 34818
(May 31, 2016).
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A. Calculation Method for Determining Whether Certain Entities Are
Subject to the IM Requirements and the Timing for Compliance With the
IM Requirements After the End of the Phased Compliance Schedule
Regulation 23.161 sets forth a schedule for compliance with the
CFTC Margin Rule, spanning from September 1, 2016, to September 1,
2022.\12\ Under the schedule, entities are required to comply with the
IM requirements in staggered phases,\13\ starting with entities with
the largest average aggregate notional amount (``AANA''), calculated on
a daily basis, of uncleared swaps, uncleared security-based swaps,
foreign exchange forwards, and foreign exchange swaps (``covered
products'') and then successively with lesser AANA. The last phase of
compliance, which begins on September 1, 2022, encompasses CSEs and
covered counterparties \14\ that did not come into the scope of the IM
requirements in prior phases, including financial end users (``FEUs'')
with material swaps exposure (``MSE'') \15\ of more than $8 billion in
AANA of covered products.\16\
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\12\ See Margin Requirements for Uncleared Swaps for Swap
Dealers and Major Swap Participants, 85 FR 71246 (Nov. 9, 2020)
(extending the phased compliance schedule for the CFTC's IM
requirements for uncleared swaps to September 1, 2022).
\13\ The schedule also addresses the VM requirements under the
CFTC Margin Rule, providing a compliance period of September 1,
2016, through March 1, 2017. See 17 CFR 23.161(a). The compliance
period (including a six-month extension to September 1, 2017,
through no-action relief) has long expired and all eligible entities
are required to comply with the VM requirements.
\14\ The term ``covered counterparty'' is defined in Regulation
23.151 as a financial end user with material swaps exposure or a
swap entity, including an SD or MSP, that enters into swaps with a
CSE. See 17 CFR 23.151.
\15\ Regulation 23.151 provides that MSE for an entity means
that the entity and its margin affiliates have an average daily
aggregate notional amount of uncleared swaps, uncleared security-
based swaps, foreign exchange forwards, and foreign exchange swaps
with all counterparties for June, July, or August of the previous
calendar year that exceeds $8 billion, where such amount is
calculated only for business days. A company is a ``margin
affiliate'' of another company if: (i) Either company consolidates
the other on a financial statement prepared in accordance with U.S.
Generally Accepted Accounting Principles, the International
Financial Reporting Standards, or other similar standards; (ii) both
companies are consolidated with a third company on a financial
statement prepared in accordance with such principles or standards;
or (iii) for a company that is not subject to such principles or
standards, if consolidation as described in paragraph (i) or (ii) of
this definition would have occurred if such principles or standards
had applied. 17 CFR 23.151.
\16\ The determination of MSE requires computing AANA,
calculated on a daily basis, of covered products over June, July and
August of the previous calendar year. For simplicity purposes, this
formulation will be referred to as ``daily average AANA'' to
contrast with month-end AANA, which is used for the calculation of
AANA under the BCBS/IOSCO Framework.
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The method for determining which entities come within the scope of
the CFTC's IM requirements beginning in the last phase of compliance,
as set forth in the Commission's regulations, differs from the method
set out in the BCBS/IOSCO Framework.\17\ More specifically, the BCBS/
IOSCO Framework requires that in the last phase of implementation of
the IM requirements, which begins on September 1, 2022, entities with
[euro]8 billion \18\ in average month-end aggregate of notional amount
(``month-end AANA'') of non-cleared derivatives, including forex
forwards and swaps, during the period of March, April, and May of the
current year, to exchange IM beginning on September 1 of each year.
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\17\ See generally BCBS/IOSCO, Margin requirements for non-
centrally cleared derivatives (July 2019), https://www.bis.org/bcbs/publ/d475.pdf (``2019 BCBS/IOSCO Framework'').
\18\ The U.S. adopted the BCBS/IOSCO threshold, but replaced the
8 billion euro figure with a dollar amount of $8 billion. As a
result, there is a small disparity in the threshold amounts given
the continuing fluctuation of the dollar-euro exchange rate. The
Final Rule does not address this issue.
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In contrast, under the CFTC Margin Rule, a CSE must exchange IM
with an FEU that has MSE with respect to uncleared swaps entered into
between the parties beginning in the last phase of compliance, which
starts on September 1, 2022. The MSE for the FEU is to be determined on
September 1, 2022, based on the FEU's daily average AANA during the
period of June, July, and August of the prior year. After the last
phase of compliance, the MSE for the FEU is to be determined on January
1 of each calendar year based on its daily average AANA during the
June, July, and August period of the prior year, with application of
the IM requirements, if the FEU has MSE, required to begin on January 1
of each year.
The BCBS/IOSCO Framework was originally promulgated in September
2013,\19\ and then revised in 2015.\20\ The 2015 version of the BCBS/
IOSCO Framework changed the calculation period of June, July, and
August, with an annual implementation date of December 1, to March,
April, and May of each calendar year, with an annual implementation
date of September 1. The CFTC Margin Rule incorporated the earlier 2013
version of the BCBS/IOSCO Framework by adopting the June, July, and
August calculation period for the annual calculation of MSE. As a
result, the Commission's existing regulations do not reflect the
calculation period of March, April, and May set forth in the revised
BCBS/IOSCO Framework published in March 2015.
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\19\ See generally BCBS/IOSCO, Margin requirements for non-
centrally cleared derivatives (Sept. 2013), https://www.bis.org/publ/bcbs261.htm.
\20\ See generally BCBS/IOSCO, Margin requirements for non-
centrally cleared derivatives (March 2015), https://www.bis.org/bcbs/publ/d317.htm.
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The Commission also departed from BCBS/IOSCO's month-end AANA
calculation for determining whether an entity is subject to the IM
requirements. The Commission decided to adopt instead daily AANA
averaging to determine whether an FEU has MSE, the finding of which
requires a CSE to exchange IM with the FEU, to gather a more
comprehensive assessment of the FEU's participation in the swaps
market, and to address the possibility that a market participant might
``window dress'' its exposure on an as-of date such as year-end, in
order to avoid the Commission's margin requirements.\21\
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\21\ 81 FR at 645. The potential for mutual funds to alter their
portfolios prior to disclosure (``window dressing'') has been
documented in the financial economics literature. See, e.g., Musto,
D. (1999). ``Investment decisions depend on portfolio disclosures.''
Journal of Finance 54, 935-952, or Agarwal, V., Gay G. and Ling, L.
(2011). ``Window dressing in mutual funds.'' Review of Financial
Studies, 27, 3133-3170.
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As a result, the Commission's current method for the annual
calculation of MSE, which was adopted in coordination with the U.S.
prudential
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regulators and is similar to the U.S. prudential regulators' method of
calculation, is not consistent with the most recent version of the
BCBS/IOSCO Framework. Nor is it consistent with requirements in other
major market jurisdictions, most of which adopted the 2015 BCBS/IOSCO
Framework's month-end AANA calculation using the period of March,
April, and May for the purposes of determining whether an entity is
subject to the IM requirements beginning in the last phase of
implementation.\22\
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\22\ See, e.g., Commission Delegated Regulation (EU) 2016/2251
Supplementing Regulation (EU) No. 648/2012 of the European
Parliament and of the Council of July 4, 2012 on OTC Derivatives,
Central Counterparties and Trade Repositories with Regard to
Regulatory Technical Standards for Risk-Mitigation Techniques for
OTC Derivative Contracts Not Cleared by a Central Counterparty (Oct.
4, 2016), Article 28(1), https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32016R2251&from=EN. Financial Services Agency of
Japan (JFSA) Cabinet Office Ordinance on Financial Instruments
Business (Cabinet Office Ordinance No. 52 of August 6, 2007), as
amended (March 31, 2016), Article 123(11)(iv); Office of the
Superintendent of Financial Institutions Canada (OSFI) Guideline No.
E-22, Margin Requirements for Non-Centrally Cleared Derivatives
(April 2020), Section 5, 71, https://www.osfi-bsif.gc.ca/Eng/Docs/e22.pdf.
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In a report prepared by a subcommittee established by the CFTC's
Global Markets Advisory Committee (``GMAC''), discussed in more detail
below, the subcommittee reported that the differences in the methods
for determining when an entity comes within the scope of the IM
requirements and the timing of compliance after the last phase of
compliance may impose an undue burden on market participants' efforts
to comply with the CFTC's margin requirements.\23\ The report stated
that entities have to account for different compliance schedules and
set up and maintain separate processes for determining when they meet
the thresholds for IM compliance.\24\
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\23\ See Recommendations to Improve Scoping and Implementation
of Initial Margin Requirements for Non-Cleared Swaps, Report to the
CFTC's Global Markets Advisory Committee by the Subcommittee on
Margin Requirements for Non-Cleared Swaps, May 2020 at, 48-54,
https://www.cftc.gov/media/3886/GMAC_051920MarginSubcommitteeReport/download (``Margin Subcommittee Report'' or ``Report'').
\24\ Id.
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B. No-Action Letter No. 19-29 Concerning the Calculation of IM
The Commission's Division of Swap Dealer and Intermediary Oversight
\25\ issued CFTC No-Action Letter 19-29 in July 2019 in response to a
request for relief submitted by Cargill Incorporated (``Cargill''), a
CFTC-registered SD and CSE.\26\ Cargill sought no-action relief to be
able to use the risk-based model calculation of IM of a counterparty
that is an SD to determine the amount of IM to be collected from the
counterparty. Cargill stated that while its swap activity primarily
involved physical agricultural commodities with non-SD counterparties
seeking to mitigate commercial risk, it maintained positions that
required the collection of IM from SDs. Given the highly specialized
and discrete nature of its swaps business, mainly focusing on
commodities, Cargill opted to rely on the standardized IM table to
calculate IM rather than develop a risk-based model. Because the use of
the standardized table could generate higher amounts of IM than a risk-
based model, requiring its SD counterparties to post higher amounts of
IM, Cargill stated that SD counterparties might choose not to trade
with it.
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\25\ Pursuant to a Commission plan of reorganization, the
Division of Swap Dealer and Intermediary Oversight was renamed
Market Participants Division (``MPD'') effective November 8, 2020.
The Division is referred to as MPD hereinafter.
\26\ CFTC Letter No. 19-29, Request for No-Action Relief
Concerning Calculation of Initial Margin (Dec.19, 2019) (``Letter
19-29''), http://www.cftc.gov/idc/groups/public/@lrlettergeneral/documents/letter/19-29.pdf.
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Based on Cargill's representations, MPD stated that it would not
recommend enforcement action, subject to specified conditions, if
Cargill used the risk-based model calculation of IM of a counterparty
that is a CFTC-registered SD as the amount of IM that Cargill was
required to collect from the SD and to determine whether the IM
threshold amount of $50 million (``IM threshold amount'') \27\ had been
exceeded, which would trigger the requirement for documentation
concerning the posting, collection, and custody of IM collateral.
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\27\ Under Regulation 23.154(a)(3), SDs and MSPs subject to the
Commission's regulations are not required to post or collect IM
until the initial margin threshold amount has been exceeded. See 17
CFR 23.154(a)(3). The term ``initial margin threshold amount'' is
defined in Regulation 23.151 to mean an aggregate credit exposure of
$50 million resulting from all uncleared swaps between an SD and its
margin affiliates (or an MSP and its margin affiliates) on the one
hand, and the SD's (or MSP's) counterparty and its margin affiliates
on the other. See 17 CFR 23.151.
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C. Market Participant Feedback
As previously mentioned, the CFTC's GMAC established a subcommittee
of market participants in January 2020 to consider issues raised by the
implementation of margin requirements for non-cleared swaps, identify
challenges associated with forthcoming implementation phases, and
prepare a report with recommendations. The subcommittee issued the
Margin Subcommittee Report and submitted the Report to the GMAC.\28\
The GMAC adopted the Report and recommended to the Commission that it
consider adopting the Report's recommendations.
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\28\ See supra note 23.
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Among other things, the Margin Subcommittee Report recommended the
alignment of the CFTC Margin Rule with the BCBS/IOSCO Framework with
respect to the method for calculating AANA for determining whether an
entity comes within the scope of the IM requirements and the timing of
compliance after the end of the phased compliance schedule.\29\ The
Report also recommended the codification of Letter 19-29.\30\
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\29\ See Margin Subcommittee Report at 48-54.
\30\ See Margin Subcommittee Report at 34-36.
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In response to feedback from market participants, in particular the
GMAC subcommittee's recommendations, the Commission issued a notice of
proposed rulemaking (``Proposal''), published in the Federal Register
on September 23, 2020, proposing amendments to the CFTC Margin Rule.
The Commission proposed to align the CFTC Margin Rule with the BCBS/
IOSCO Framework with respect to the method for calculating AANA for
determining whether certain entities come within the scope of the IM
requirements and the timing of compliance after the end of the phased
compliance schedule, noting that BCBS/IOSCO is the global standard
setter for margin requirements for non-centrally cleared derivatives
and that the proposed amendments would promote international
harmonization in the application of the IM requirements. The Commission
stated that the disjunction between the CFTC and BCBS/IOSCO concerning
the calculation of AANA and the timing of compliance with the IM
requirements does not further any regulatory purpose, noting, in
particular, the foreseeability of calculation errors resulting from
differences in the calculation methods.\31\
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\31\ The possibility of calculation errors may be mitigated by
substituted compliance, as described in Regulation 23.160, if the
parties are non-U.S. entities and substituted compliance is
available, as the parties may be able to avail themselves of the
rules in the foreign jurisdiction and may therefore not face the
concern about different calculation methods. However, while the
changes to the method of calculation of AANA under the Final Rule
will align the CFTC's method of calculation with BCBS/IOSCO's
approach, the Commission acknowledges that the changes will result
in a divergence from the U.S. prudential regulators' approach, which
may increase the potential for calculation errors for entities
located in the United States.
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The Commission also proposed to amend the CFTC Margin Rule to
permit CSEs to use the risk-based IM calculation of a counterparty that
is a
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CFTC-registered SD or MSP, in line with the terms of Letter 19-29. The
Commission stated that this amendment would promote legal certainty and
clarity, facilitating efforts by market participants to take the
application of the Commission's regulations into account in planning
their uncleared swaps business, without undermining the effectiveness
of the CFTC Margin Rule.
The Commission stated that the more widespread availability of the
relief provided by Letter 19-29 would promote efficient risk hedging by
smaller CSEs that offer swaps services to smaller entities that are
neither SDs nor MSPs. The Commission further noted that having the
ability to use the risk-based IM calculation of a counterparty that is
an SD or MSP would allow smaller CSEs to engage SDs and MSPs that
otherwise might be disincentivized from trading with the CSEs. That is
because for such CSEs, the single method of IM calculation available
may be the standardized IM table, as the CSEs, given the discrete and
limited nature of their swaps business, may find it uneconomical to
develop and maintain a proprietary model. As a result, swap entity
counterparties may be required to post higher amounts of IM to the
CSEs, as the table-based method of calculation does not account for
portfolio composition, diversification and hedges.
In the preamble to the Proposal, the Commission sought comment from
the public on the proposed amendments.\32\ The comment period for the
Proposal closed on October 23, 2020, and nine comment letters were
received: one from an SD in the gas and electric power industry; \33\
one from an SD in the oil and gas industry; \34\ one from a life
insurance trade association; \35\ one from a group of swaps and
financial industry advocates; \36\ one from a futures industry group
representing members active in the physical commodities markets; \37\
one from a managed fund industry group; \38\ one from a regulated funds
association; \39\ one from a representative of the asset management
industry; \40\ and one from a group of commercial firms in the energy
industry.\41\
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\32\ Margin Requirements for Uncleared Swaps for Swap Dealers
and Major Swap Participants, 85 FR 59702 (Sept. 23, 2020). The
comment letters for the Proposal are available at: https://comments.cftc.gov/PublicComments/CommentList.aspx?id=4157.
\33\ Letter from Jennifer Minnis, BP Energy Company (Oct. 23,
2020) (BPEC 10/23/2020 Letter).
\34\ Letter from Scott Earnest, Shell Trading Risk Management,
LLC (Oct. 23, 2020) (STRM 10/23/2020 Letter).
\35\ Letter from Michael Lovendusky, American Council of Life
Insurers (Oct. 23, 2020) (ACLI 10/23/2020 Letter).
\36\ Letter from Tara Kruse, James Kemp, and Kyle Brandon for
International Swaps and Derivatives Association (ISDA), Global
Foreign Exchange Division (GFXD) of the Global Financial Markets
Association, and Securities Industry and Financial Markets
Association, respectively, (collectively, ``Associations'') (Oct.
22, 2020) (Associations 10/22/2020 Letter).
\37\ Letter from Allison Lurton, Financial Industry Association
(Oct. 22, 2020) (FIA 10/22/2020 Letter).
\38\ Letter from Jennifer W. Han, Managed Funds Association
(Oct. 22, 2020) (MFA 10/22/2020 Letter).
\39\ Letter from Sarah A. Bessin, Investment Company Institute
(Oct. 22, 2020) (ICI 10/22/2020 Letter).
\40\ Letter from Jason Silverstein, Asset Management Group of
the Securities Industry and Financial Markets Association (Oct. 22,
2020) (SIFMA AMG 10/22/2020 Letter).
\41\ Letter from Alexander S. Holtan, Commercial Energy Working
Group (Oct. 22, 2020) (Working Group 10/22/2020 Letter).
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II. Final Rule, Summary of Comments and Commission Response
The Commission is adopting revisions to the method for calculating
AANA for determining whether an FEU has MSE and the timing for
compliance with the IM requirements after the end of the last phase of
compliance to align these aspects of the CFTC Margin Rule with the
BCBS/IOSCO Framework, as proposed. The Commission is also amending
Regulation 23.154(a), consistent with the terms of Letter 19-29, and
thus allowing CSEs to use the risk-based model calculation of IM of
counterparties that are CFTC-registered SDs or MSPs (``swap entities'')
\42\ to determine the amount of IM to be collected from such
counterparties.
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\42\ Regulation 23.151 defines the term ``swap entity'' as a
person that is registered with the Commission as an SD or MSP under
the CEA.
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All the comment letters received on the Proposal generally
expressed support for the proposed amendments \43\ and the Commission's
efforts to identify and address challenges in the implementation of the
CFTC's margin requirements as the phased compliance schedule nears
conclusion.\44\ Commenters expressed support for the Proposal even in
the absence of parallel action by the U.S. prudential regulators, while
urging the CFTC to continue coordination with the prudential regulators
and encourage corresponding amendments to the prudential regulators'
margin rules so that prudentially regulated SDs and MSPs and their
counterparties are not disadvantaged by requirements that are neither
globally nor domestically harmonized.\45\
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\43\ See ACLI 10/23/2020 Letter at 1; Associations 10/22/2020
Letter at 1; BPEC 10/23/2020 Letter at 2; FIA 10/22/2020 Letter at
2-3; ICI 10/22/2020 Letter at 1; MFA 10/22/2020 Letter at 1; SIFMA
AMG 10/22/2020 Letter at 1; STRM 10/23/2020 Letter at 1; Working
Group 10/22/2020 Letter at 3. A commenter stated that the Proposal
reflects the realities of the marketplace and further aligns the
U.S. regulations with the global regulators. See ACLI 10/23/2020
Letter at 2. Other commenters stated that the Proposal would enable
the implementation of the IM requirements in a practical and
efficient manner, as market participants prepare for forthcoming
compliance dates, reducing complexity and burden associated with
implementation and would foster greater liquidity and contribute to
the lowering of hedging costs, particularly in the last phases of
the compliance schedule. See BPEC 10/23/2020 Letter at 2; MFA 10/22/
2020 Letter at 2.
\44\ While expressing support for the Proposal, commenters asked
the Commission to consider other issues raised by the CFTC Margin
Rule, including whether to exclude commodity swaps from the CFTC's
uncleared margin requirements, the need to harmonize the definition
of financial entity under section 2(h)(7) of the CEA and the
definition of financial end user under the CFTC Margin Rule, whether
treasury affiliates of an SD should be exempt from the CFTC's
uncleared margin requirements, and other topics raised in prior
communications to the Commission. See FIA 10/22/2020 Letter at 2;
MFA 10/22/2020 Letter at 2. The commenters also asked the Commission
to consider other recommendations from the Margin Subcommittee
Report not addressed in the Proposal. See ACLI 10/23/2020 Letter at
2; Associations 10/22/2020 Letter at 1; SIFMA AMG 10/22/2020 Letter
at 4. The Commission will not currently act on these additional
matters as they fall outside the scope of the Proposal. The
Commission is aware of these issues and will continue to consider
them and monitor pertinent developments to determine whether further
Commission action concerning these matters is appropriate in the
future.
\45\ ACLI 10/23/2020 Letter at 1; Associations 10/22/2020 Letter
at 4; MFA 10/22/2020 Letter at 2.
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A. Regulation 23. 151--Amendments to MSE Definition
As noted above, a CSE must exchange IM with respect to uncleared
swaps with a counterparty that is an FEU that has MSE beginning in the
last phase of the phased compliance schedule, which will start on
September 1, 2022.\46\ Regulation 23.151 provides that an entity has
MSE if it has more than $8 billion in AANA, calculated on a daily
basis, during June, July, and August of the prior year.\47\ An FEU that
has MSE based on the calculation of AANA over June, July, and August of
2021 would come within the scope of the IM requirements beginning on
September 1, 2022. In subsequent calendar years after September 1,
2022, however, because the base year for calculating AANA is the prior
year, the annual determination of MSE, which triggers the applicability
of the IM requirements, would be January 1 of each year,\48\ using the
[[Page 233]]
AANA for June, July, and August of the prior year. If the FEU has MSE
on January 1 of a given year, the FEU would come within the scope of
the IM requirements on January 1 of such year. As such, a CSE would be
required to exchange regulatory IM beginning on such January 1 for its
uncleared swaps with such FEU.
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\46\ See 17 CFR 23.161(a)(7) (requiring CSEs to comply with the
CFTC's IM requirements with respect to uncleared swaps with
counterparties that are FEUs with MSE beginning on September 1,
2022).
\47\ For definition of MSE, see supra note 15.
\48\ January 1 is not explicitly set out in the Commission's
regulations as the determination date for MSE after the last phase
of compliance. However, absent the Final Rule, Regulation
23.161(a)(7) (addressing the last phase of compliance and the timing
of compliance going forward) and the definition of MSE in Regulation
23.151 can be reasonably read together to set January 1 as the MSE
determination date. See 17 CFR 23.151; 17 CFR 23.161(a)(7).
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As proposed, the Commission is amending the definition of MSE in
Regulation 23.151 by replacing ``June, July and August of the previous
calendar year'' with ``March, April and May of that year.'' The period
for calculating AANA for determining whether an FEU has MSE will thus
be March, April, and May of ``that year.'' ``That year'' will be
understood to mean the year the MSE status for an FEU is assessed for
the purpose of determining whether a CSE that enters into uncleared
swaps with the FEU is required to exchange IM with the FEU.
The Commission is also amending the definition of MSE to set
``September 1 of any year'' as the determination date for MSE. Under
the current requirements, absent a rule change, the MSE for an FEU
would have to be determined first on September 1, 2022, which would
begin the last phase of compliance under the phased compliance
schedule, and subsequently, after the end of the phased compliance
schedule, on January 1 of each year. Under the Final Rule, the date for
the determination of MSE after the end of the phased compliance
schedule will shift from January 1 to September 1. The change in the
MSE determination date to September 1 of each year effectively sets the
timing for compliance with the IM requirements on September 1 after the
end of the phased compliance schedule with respect to uncleared swaps
entered into by a CSE and an FEU with MSE.
The shift of the MSE determination date from January 1 to September
1 may defer for nine months to September 1, 2023, the obligation to
exchange IM for a firm that absent the rule change would have been
subject to the IM requirements on January 1, 2023. Uncleared swaps
entered into by the firm during the nine-month deferral period will be
deemed legacy swaps, or uncleared swaps exempt from the IM
requirements.\49\ As a result, in 2023, less collateral may be
collected for uncleared swaps, which could render uncleared swap
positions riskier and increase the risk of contagion and systemic risk.
The Commission, however, notes that because the deferral period will
affect entities with lower AANAs than entities brought into scope in
earlier phases of the IM compliance schedule, the potential
uncollateralized risk would be mitigated, becoming a lesser concern,
particularly because the proposed change in the MSE determination date
will draw the Commission's rules closer to BCBS/IOSCO's approach,
promoting international harmonization.
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\49\ Pursuant to Regulation 23.161, the compliance dates for the
IM and VM requirements under the CFTC Margin Rule are staggered
across a phased schedule that extends from September 1, 2016, to
September 1, 2022. The compliance period for the VM requirements
ended on March 1, 2017 (though the CFTC and other regulators
provided guidance permitting a six-month grace period to implement
the requirements following the implementation date), while the IM
requirements continue to phase in through September 1, 2022. An
uncleared swap entered into prior to an entity's IM compliance date
is a ``legacy swap'' that is not subject to the IM requirements. See
CFTC Margin Rule, 81 FR at 651 and Regulation 23.161. 17 CFR 23.161.
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Conversely, the change in the MSE determination date could also
result in requiring certain entities to post and collect IM that
otherwise would not have been required to do so. This could occur when
an FEU meets the MSE threshold in the last phase of compliance
beginning on September 1, 2022, but falls below the threshold by
January 1, 2023, because the AANA for June, July, and August of the
prior year (i.e. 2022) is below $8 billion. In such case, under the
current rule, a CSE would no longer be required to exchange IM with
such FEU beginning on January 1, 2023. However, the change in the MSE
determination date to September 1, as adopted, will require the CSE to
continue to exchange IM with the FEU through September 1, 2023, as no
determination of MSE status will be required between September 1, 2022,
and September 1, 2023, and, as a result, the CSE will be required to
exchange IM with the FEU for nine months longer than the January 1,
2023 MSE determination date would have required.
These amendments to the definition of MSE will have the effect of
reducing the time frame that FEUs and their CSE counterparties will
have to prepare for compliance with the IM requirements. Under the
current rule being amended, CSEs would have been required to exchange
regulatory IM with counterparties that are FEUs with MSE beginning on
September 1, 2022, which starts the last phase of the phased compliance
schedule. The MSE for the FEU would have been determined using the AANA
for June, July, and August of the prior year (i.e., 2021). As a result,
for the last phase of compliance in 2022, a CSE and FEU would have had
at least twelve months to prepare for compliance with the IM
requirements. By contrast, under the Final Rule, a CSE and FEU, for the
last phase of compliance in 2022, will have only 3 months to prepare
for IM compliance because MSE will be required to be determined using
the AANA for March, April, and May of the current year (i.e., 2022).
Also, under the Final Rule, after the last phase of compliance
under the phased compliance schedule, the date for determining MSE for
an FEU will be September 1 of each year, and the AANA calculation
period for determining whether an FEU has MSE will be March, April, and
May of such year. As a result, an FEU with MSE and its CSE counterparty
will have three months to prepare in advance of compliance with the IM
requirements, whereas under the current rule being amended, such
parties would have had four months because MSE would have been required
to be determined on January 1 based on the AANA for June, July, and
August of the prior year.
In its Margin Subcommittee Report, the GMAC subcommittee
acknowledged that the change in the period for the calculation of AANA
and the change in the MSE determination date from January 1 to
September 1 would reduce the time frame for preparing for compliance
with the IM requirements.\50\ Nevertheless, the subcommittee expressed
support for the changes, noting that the changes would align the CFTC's
margin requirements with the BCBS/IOSCO Framework.\51\
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\50\ See Margin Subcommittee Report at 49.
\51\ Id. (The GMAC subcommittee stated that the divergence
between the U.S. and international requirements ``creates complexity
and confusion, and leads to additional effort, cost and compliance
changes for smaller market participants that are generally subject
to margin requirements in multiple global jurisdictions.'').
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The Commission is also amending the definition of MSE to replace
``average daily aggregate notional amount,'' or daily average AANA,
with ``average month-end aggregate notional amount,'' for calculating
AANA to determine whether an entity has MSE. In adopting the CFTC
Margin Rule, the Commission acknowledged that month-end AANA averaging
for the calculation of AANA would be consistent with BCBS/IOSCO's
approach. Nonetheless, the CFTC, along with the U.S prudential
regulators, decided to adopt daily AANA averaging for the calculation
of AANA to determine MSE. In the preamble to the CFTC Margin Rule, the
[[Page 234]]
Commission explained that daily average AANA would provide a more
comprehensive assessment of an FEU's participation in the swaps market
in determining whether the FEU has MSE and would address the
possibility of window dressing of exposures by market participants that
might seek to avoid the CFTC's margin requirements.\52\
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\52\ See supra note 21.
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In its Report, the GMAC subcommittee stated that the use of daily
average AANA for the calculation AANA entailed more work for smaller
counterparties and that such method of calculation was only used in the
United States, noting that in the United States, daily AANA averaging
over the three-month calculation period for Phase 5 \53\ required 64
observations while global determinations based on month-end AANA
required only three observations.\54\ The Report further stated that
month-end AANA averaging over the three-month calculation period, by
accounting for three periodic dates on which AANA would be calculated,
would mitigate the risk that market participants would adjust exposures
to avoid the CFTC's margin requirements, and that it would be neither
practicable nor financially desirable for parties to tear-up their
positions on a recurring basis prior to each month-end AANA
calculation, as it would interfere with their hedging strategies and
cause them to incur realized profit and loss.\55\
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\53\ As used in the Margin Subcommittee Report, Phase 5 meant
the phase of compliance with the CFTC's IM requirements that started
on September 1, 2020, comprising covered swap entities and covered
counterparties with AANA between $750 billion and $50 billion. Since
the issuance of the Report, the IM compliance schedule has been
revised to defer the beginning of Phase 5 to September 1, 2021. See
17 CFR 23.161(a)(6).
\54\ Margin Subcommittee Report at 52.
\55\ Id.
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The Commission notes that the adoption of a month-end AANA
methodology for the calculation of AANA to determine MSE will align the
CFTC's approach with the BCBS/IOSCO Framework and the approach adopted
by other major market jurisdictions. The Commission does acknowledge
that such methodology for calculating AANA could raise the risk that
market participants that are counterparties to CSEs may ``window
dress'' their exposures by adjusting their exposures as they approach
the month-end date. By doing so, an FEU would no longer have to post
and collect IM with all CSEs for all its uncleared swaps for at least
twelve months from the date on which compliance with the IM
requirements would have been initially required.\56\
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\56\ Under the Final Rule, the MSE calculation will be made
annually on September 1 of each year and will be in effect for the
next twelve months after that date.
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To address this concern, the Commission has determined to revise
the proposed rule text to include anti-evasion language prohibiting
activities not carried out in the ordinary course of business and
willfully designed to circumvent the month-end AANA calculation by, for
example, altering swap book composition to evade meeting the definition
of MSE and thus coming within the scope of the CFTC's IM requirements.
In addition, the Commission points to the availability of other tools
to address the risk of ``window dressing.'' Regulation 23.402(a)(ii)
requires CSEs to have written policies and procedures to prevent their
evasion, or participation in or facilitation of an evasion, of any
provision of the CEA or the Commission's regulations.\57\ Also, section
4b of the CEA prohibits any person entering into a swap with another
person from cheating or defrauding or willfully deceiving or attempting
to deceive the other person.\58\
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\57\ 17 CFR 23.402(a)(ii).
\58\ 7 U.S.C. 6b.
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The Commission further notes that replacing daily average AANA with
month-end AANA for determining MSE could result in an AANA calculation
that is not fully representative of an entity's participation in the
swaps markets. Under the current definition of MSE, AANA must be
calculated counting uncleared swaps, uncleared security-based swaps,
foreign exchange forwards, or foreign exchange swaps. Under the Final
Rule, which provides for the calculation of AANA by averaging month-end
AANA during the three-month calculation period, some of the financial
products that are required to be included in the calculation, because
of their terms, such as tenure and time of execution, may be
undercounted or excluded.\59\
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\59\ For example, the Commission observes that certain physical
commodity swaps, such as electricity and natural gas swaps, are
products for which a month-end AANA calculation might not provide a
comprehensive assessment of the full scope of an FEU's exposure to
those products.
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The Commission believes that the notional amount associated with
products that may be excluded from the AANA calculation, as a result of
the change to month-end AANA averaging for the calculation of AANA, may
be relatively low and that the products' contribution to the AANA
calculation for the purpose of determining MSE may be insignificant. In
this regard, in an analysis undertaken by the Commission's Office of
the Chief Economist (``OCE'') on a sample of days, the OCE estimated
(setting aside the window dressing issue) that calculations based on
end-of-month AANA would yield fairly similar results as calculations
based on the current daily average AANA approach. Based on 2020 swap
data, the OCE estimated that 492 entities of the 514 entities that
would have come into scope in the last phase of the IM compliance
schedule (with AANA between $8 and $50 billion) based on the current
daily AANA calculation methodology would also come into scope under the
month-end AANA calculation methodology being adopted herein. Put
differently, all but 22 of the entities that would be above MSE under
the existing methodology would also be above MSE under the month-end
AANA methodology. In addition, there are 20 entities that would be in
scope under the month-end AANA methodology, but would not be in scope
under the existing methodology, so that the aggregate number of
entities under the two methodologies differs only by two.
In the aggregate, the two methodologies capture quite similar sets
of entities. In addition, the entities that fall out of scope applying
the month-end AANA methodology tend to be among the smallest coming
into IM compliance in the last phase of compliance. That is, entities
that would have been in-scope under the current daily average AANA
methodology but not the month-end AANA methodology average $6.95
billion in AANA, compared to $20 billion for all entities coming into
scope in the last phase of compliance.\60\
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\60\ Note that the OCE calculation excludes commodity swaps, and
the examples of products that end-of-month calculations may
undercount tend to be commodity swaps, such as natural gas and
electricity swaps. Overall, commodity swaps tend to represent less
than 1% of all swap trades. See BIS Statistic Explorer, Global OTC
derivatives market (July 30, 2020), https://stats.bis.org/statx/srs/table/d5.1?f=pdf.
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Based on the OCE analysis discussed above, in the Commission's
view, switching from daily average AANA to month-end AANA for the
purpose of determining MSE would likely have a limited impact on the
protections provided by the CFTC Margin Rule. In addition, the
Commission believes that the anti-evasion language being incorporated
into the rule text by this Final Rule mitigates the window dressing
concerns.\61\
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\61\ The prudential regulators have not indicated whether they
intend to amend their margin requirements consistent with the BCBS/
IOSCO Framework and the amendments to the definition of MSE
discussed herein. Also of note, the U.S. Securities and Exchange
Commission (``SEC'') has adopted a different approach that does not
use MSE for identifying entities that come within the scope of the
SEC margin requirements. See Capital, Margin, and Segregation
Requirements for Security-Based Swap Dealers and Major Security-
Based Swap Participants and Capital and Segregation Requirements for
Broker-Dealers, 84 FR 43872 (Aug. 22, 2019).
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[[Page 235]]
Commenters expressed strong support for the amendments to the MSE
definition in Regulation 23.151 to align the method for calculating
AANA and the timing of compliance with the IM requirements after the
end of the last phase of compliance with the BCBS/IOSCO Framework.\62\
Commenters stated that the amendments would help smaller market
participants overcome unnecessary operational challenges. \63\ The
commenters also stated that the amendments would help entities that
conduct swaps business across jurisdictions.\64\ A commenter stated
that the differences in the AANA calculation methods and the timing of
compliance burden market participants, such as asset managers, in
determining whether clients are in scope in the later phases of the
compliance schedule and create a complex and confusing ongoing
monitoring process.\65\
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\62\ See ACLI 10/23/2020 Letter at 1; Associations 10/22/2020
Letter at 2; FIA 10/22/2020 Letter at 4; MFA 10/22/2020 Letter at 1;
SIFMA AMG 10/22/2020 Letter at 2; Working Group 10/22/2020 Letter at
3.
\63\ SIFMA AMG 10/22/2020 Letter at 1; ACLI 10/23/2020 Letter at
2.
\64\ Id.
\65\ Id.
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Another commenter noted that the U.S. is the only jurisdiction that
requires using the three-month period of June, July and August of the
preceding year for the calculation of AANA, and the only jurisdiction
besides Brazil that requires AANA to be calculated using daily
averaging rather than month-end averaging over the three-month
period.\66\ The commenter stated that a jurisdiction-specific approach
creates additional effort for smaller counterparties coming into scope
in the later phases of the compliance schedule, which need to run
separate AANA calculations using different time periods and methods and
need to provide separate notifications to their counterparties
concerning the application of the IM requirements.\67\ The commenter
stated that according to its estimates, 775 counterparties with a total
of 5,443 relationships could come into the scope of global IM
requirements in the last phase of compliance beginning September 1,
2022, and that over 74% of those counterparties will qualify for the IM
requirements with less than EUR 25 billion AANA and therefore may be in
a position to recalculate their AANA each year to affirm the continued
application of the IM requirements.\68\ In addition, hundreds of other
counterparties that do not initially breach the $8 billion threshold
will need to conduct annual AANA calculations to confirm whether they
have come into scope of the IM requirements in one or more
jurisdictions.\69\ The commenter concluded by stating that
jurisdictional differences are difficult to track and manage, leading
to inadvertent errors or omissions in the calculations and the
application of IM requirements, and that the differences could
interfere with the ability to apply substituted compliance, since a
party may become subject to the IM requirements under the CFTC Margin
Rule on a different date in the U.S. as they will in other global
jurisdictions.\70\
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\66\ Associations 10/22/2020 Letter at 2.
\67\ Id.
\68\ Id.
\69\ Id.
\70\ Id.
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Addressing concerns that the month-end AANA methodology for
determining MSE may result in window dressing, a commenter stated that
it was not a realistic risk, as it would take considerable effort for
parties to unwind their positions and then reestablish the position on
a recurring basis over the three-month period, which would interrupt
their hedging strategies and require the counterparties to absorb the
cost of realized profit and loss changes.\71\ Another commenter echoed
these arguments, noting that tearing up positions may interfere with
hedging and cause portfolios to incur realized profit and loss
changes.\72\ A commenter, speaking on behalf of the managed fund
industry, stated that adjustments to swaps positions to benefit from
the month-end AANA methodology would be contraindicated in the case of
an investment adviser to a regulated fund because the investment
adviser is a fiduciary to the fund that is legally obligated to manage
the fund's assets in accordance with that fund's investment strategy,
policies, and limitations.\73\ Adjusting swap exposures over the course
of three periodic dates solely to avoid IM could impose transaction
costs and inhibit a fund's ability to manage its portfolio risk, which
may be inconsistent with the adviser's duty to act in the best interest
of its clients.\74\ Another commenter representing the life insurance
industry stated that the proposed changes to the calculation of AANA
would be unlikely to change the life insurers' market behavior given
that life insurers are subject to significant state regulation of their
derivatives activities.\75\
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\71\ Id.
\72\ SIFMA AMG 10/22/2020 Letter at 3.
\73\ ICI 10/22/2020 Letter at 5.
\74\ Id.
\75\ ACLI 10/23/2020 Letter at 2.
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While recognizing that practical considerations, as discussed by
the commenters, may reduce the risk of window dressing, the Commission
believes that it should seek to remove any potential incentives that
may lead to the manipulation of swaps exposures to avoid meeting the
definition of MSE and thus coming within the scope of the margin
requirements. Accordingly, as discussed further above, the Commission
is revising the proposed rule text to incorporate an anti-evasion
provision prohibiting activities willfully designed to avoid the month-
end AANA calculation.
With respect to the divergence between the CFTC and the U.S.
prudential regulators regarding the method for calculating AANA for
determining whether an entity has MSE and the timing of compliance
after the last phase of the compliance schedule, commenters stated that
the CFTC should proceed with the amendments even if the prudential
regulators do not make corresponding changes to their margin rules
while also encouraging the prudential regulators to align with the
global standards.\76\ A commenter further noted that given that most
affected FEUs belong to a corporate group that has to calculate AANA
for multiple jurisdictions, a deviation between the CFTC and prudential
regulators would not increase the regulatory burden for most FEUs as
they would already be calculating AANA under the CFTC/prudential
regulator approach and the BCBS/IOSCO approach.\77\
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\76\ SIFMA AMG 10/22/2020 Letter at 3; Working Group 10/22/2020
Letter at 2.
\77\ Working Group 10/22/2020 Letter at 3.
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After reviewing the comments, the Commission has confirmed the
rationale articulated for proposing the amendments to the definition of
MSE in Regulation 23.151 and is therefore adopting the amendments as
proposed, subject to the change to the proposed rule text to add the
anti-evasion provision discussed in more detail above. The Commission
believes, as discussed in the preamble to the Proposal, that the
amendments will eliminate the need to maintain separate schedules and
processes for the computation of AANA and reduce the burden and cost of
compliance with the
[[Page 236]]
IM requirements.\78\ In addition, section 752(a) of the Dodd-Frank Act
calls on the CFTC to ``consult and coordinate'' with respect to the
establishment of consistent international standards.\79\ As such, the
Commission believes that amending the definition of MSE, as proposed,
is appropriate to harmonize its compliance schedule with that of BCBS/
IOSCO and, for entities engaging in swaps with CSEs, eliminates a
disjunction that could risk calculation errors and may hinder
compliance with the IM requirements.
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\78\ The Commission acknowledges that the burdens on market
participants will not be fully eliminated, and in fact, may
increase, for those entities that enter into uncleared swaps with
SDs and MSPs that are subject to the U.S. prudential regulators'
margin requirements for uncleared swaps and come within the scope of
the prudential regulators' margin regime, as the prudential
regulators have not revised their rules consistent with the rule
changes being adopted herein. Any further discussion in this Final
Rule of the benefits of not needing to maintain separate schedules
and processes is limited to entities not also undertaking swaps with
U.S. prudentially regulated SDs.
\79\ See section 752(a) of the Dodd-Frank Wall Street Reform and
Consumer Protection Act, Public Law 111-203, 124 Stat. 1376 (2010).
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B. Regulation 23.154--Alternative Method of Calculation of IM
As originally adopted, the CFTC Margin Rule requires CSEs to
collect and post IM with covered counterparties, including CFTC-
registered SDs or MSPs.\80\ Regulation 23.154(a) directs CSEs to
calculate, on a daily basis, the IM amount to be collected from covered
counterparties.\81\ CSEs have the option to calculate the IM amount by
using either a risk-based model or the standardized IM table set forth
in Regulation 23.154(c)(1).\82\ For a CSE that elects to use a risk-
based model to calculate IM, Regulation 23.154(b)(1) requires the CSE
to obtain the written approval of the Commission or a registered
futures association \83\ to use the model to calculate IM required by
the Commission's margin requirements for uncleared swaps.\84\
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\80\ See 17 CFR 23.152.
\81\ See 17 CFR 23.154(a).
\82\ See id.
\83\ See 17 CFR 23.154(b)(1)(i). In this context, the term
``registered futures association'' refers to the National Futures
Association (``NFA''), which is the only futures association
registered with the Commission.
\84\ See 17 CFR 23.154(b)(1)(i).
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After reviewing the comments on the Proposal, the Commission is
adopting the amendment to Regulation 23.154(a) as proposed, subject to
some clarifications further discussed below. More specifically, the
Commission is amending Regulation 23.154(a) by adding new paragraph
(a)(5). Paragraph (a)(5) permits a CSE that enters into uncleared swaps
with a CFTC-registered SD or MSP, or a swap entity, to use the swap
entity's risk-based model calculation of IM to determine the amount of
IM that must be collected from such counterparty and to determine
whether the IM threshold amount has been exceeded, which would require
documentation concerning the posting, collection, and custody of IM.
This amendment to Regulation 23.154(a) modifies, consistent with
Letter 19-29, the requirement that CSEs calculate the amount of IM to
be collected from a swap entity counterparty by giving CSEs the option
to rely on such counterparty's risk-based IM calculation. The
Commission acknowledges that as a result, some CSEs may forgo the
adoption of a risk-based model to avoid the cost and burden associated
with developing and maintaining such a model. The Commission notes that
without a model to compute its own IM, a CSE may lack reasonable means
to verify the IM amount provided by its counterparty or may fail to
recognize shortfalls in the IM calculation or flaws in the
counterparty's risk-based model. As such, the CSE may collect
insufficient amounts of IM to offset counterparty risk. In addition,
the Commission acknowledges the swap entity's potential conflict of
interest in calculating IM for the CSE, \85\ as it may be biased in
favor of calculating and posting lower amounts of IM to the CSE.
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\85\ The Commission, however, notes that the potential for
conflict may be mitigated as the swap entity, as a CFTC-registered
SD or MSP, would be subject to Regulation 23.600, which requires SDs
and MSPs to establish a risk management program for the management
and monitoring of risk, including credit and legal risk, associated
with their swap activities. See 17 CFR 23.600.
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Based on the foregoing concerns, the Commission is adopting, as
part of the new paragraph (5) in Regulation 23.154(a), two of the
conditions set forth in Letter 19-29.\86\
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\86\ As previously discussed, Letter 19-29 permits Cargill to
use the risk-based IM calculation of a counterparty that is a CFTC-
registered SD to determine the amount of IM to be collected from
such counterparty, subject to specified conditions discussed in more
detail below.
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First, consistent with Letter 19-29, paragraph (a)(5) requires that
the risk-based model used by the CSE's swap entity counterparty for the
calculation of IM satisfy the requirements of Regulation 23.154(b)
(requiring the approval of the use of the model by either the
Commission or the NFA), or that the model be approved by a prudential
regulator.\87\
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\87\ The prudential regulators have not amended their margin
requirements for uncleared swaps consistent with the amendment to
Regulation 23.154(b) discussed herein. As such, the CFTC's margin
requirements will diverge from the prudential regulators' approach.
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Second, paragraph (a)(5) permits CSEs to use the risk-based model
calculation of IM of a swap entity counterparty only if the uncleared
swaps for which IM is calculated are entered into for the purpose of
hedging the CSE's own risk. The risk to be hedged is understood to be
the risk that a CSE would incur when entering into swaps with non-swap
entity counterparties. By limiting the application of this alternative
method of calculation of IM to only uncleared swaps entered into for
the purpose of hedging risk arising from swaps entered into with non-
swap entities, the Commission ensures the narrow application of this
method of calculation.
The Commission contrasts the risk of customer-facing swaps with the
risk that CSEs incur when entering into a swap in a dealing capacity
``to accommodate the demand'' of a swap entity counterparty.\88\ The
Commission believes that it would be inappropriate to allow a CSE to
use the IM calculation of the swap entity counterparty in this latter
case. The Commission notes that the latter case (i.e., where the CSE is
acting in a dealing capacity for a counterparty that is itself
calculating IM) would occur in the inter-dealer market for swaps. The
Commission believes that a CSE participating in the inter-dealer market
in a dealing capacity should have the capacity to develop, implement,
and use an approved risk-based model.
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\88\ See Further Definition of ``Swap Dealer,'' ``Security-Based
Swap Dealer,'' ``Major Swap Participant,'' ``Major Security-Based
Swap Participant'' and ``Eligible Contract Participant,'' 77 FR
30596, 30608 (May 23, 2012) (noting that a distinguishing
characteristic of swap dealers is being known in the industry for
their availability to accommodate demand for swaps).
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The Commission expects that new paragraph (a)(5) would be relied
upon by CSEs that opt not to develop and obtain approval to use a risk-
based model for the calculation of IM but instead elect to use the
table-based calculation described in Regulation 23.154(c) for swaps
with non-swap entity counterparties. Such CSEs, in the course of their
uncleared swaps business, would enter into uncleared swaps mostly with
end-user, non-swap entity counterparties, and hedge the risk of those
swaps with other uncleared swaps entered into with swap entity
counterparties. The CSEs would exchange IM with the swap entity
counterparties for the uncleared swaps entered into for their own
hedging, as the swaps would be subject to the CFTC
[[Page 237]]
IM requirements.\89\ Because maintaining a risk-based model imposes a
disproportionate burden on the CSEs relative to the discrete and
limited nature of their uncleared swap activities, the CSEs would
generally not have a model for the calculation of IM, and thus new
paragraph (a)(5) will permit them to use the risk-based model
calculation of their swap entity counterparties to determine the amount
of IM to be collected from such counterparties.
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\89\ See generally 17 CFR 23.152 (requiring CSEs to exchange IM
with swap entity counterparties for their uncleared swaps).
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Letter 19-29, in addition to the foregoing conditions, requires
that Cargill, prior to using the risk-based model calculation of IM of
a swap entity counterparty, agree with its counterparty in writing that
the IM calculation be provided to Cargill in a manner and time frame
that would allow Cargill to comply with the CFTC Margin Rule and other
applicable Commission regulations, and that the calculation be used to
determine the amount of IM to be collected from the counterparty and to
determine whether the IM threshold amount has been exceeded, which
would require documentation addressing the posting, collection, and
custody of IM. While the Commission acknowledges that the application
of the alternative method of calculation of IM adopted herein could
potentially result in the miscalculation or underestimation of IM, it
believes that the safeguards in Part 23 of the Commission's
regulations, such as the documentation requirements in Regulations
23.158 and 23.504, address this concern.
Regulation 23.158(a) requires CSEs to comply with the documentation
requirements set forth in Regulation 23.504.\90\ Regulation
23.504(b)(4)(i) requires CSEs to have written documentation reflecting
the agreement with a counterparty concerning methods, procedures,
rules, and inputs for determining the value of each swap at any time
from execution to the termination, maturity, or expiration of such swap
for the purposes of complying with the margin requirements under
section 4s(e) of the Act and regulations under this part.\91\
Regulation 23.504(b)(3)(i) also provides that the documentation shall
include credit support arrangements, including initial and variation
margin requirements, if any.\92\
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\90\ 17 CFR 23.158(a).
\91\ 7 U.S.C. 6s(e);17 CFR 23.504(b)(4)(i).
\92\ Regulation 23.504(b)(1) further provides that the
documentation should include all terms governing the trading
relationship between an SD or MSP and its counterparty, including
without limitation, terms addressing payment obligations, netting of
payments, events of default or other termination events, calculation
and netting of obligations upon termination, valuation, and dispute
resolution. 17 CFR 23.504(b)(1).
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Letter 19-29 also sets forth two conditions that are designed to
ensure that Cargill will undertake adequate risk management with
respect to its uncleared swaps. The Commission notes that the
availability of the alternative method of calculation of IM may lead
some CSEs to forgo the adoption of a proprietary risk-based model for
the calculation of IM. Without a proprietary risk-based model, CSEs may
not be able to precisely calculate IM, or the potential future exposure
of uncleared swaps, which could undercut a CSE's ability to adequately
manage the risk of its swaps. However, the Commission believes that
CSEs' risk management obligations under the CEA and the Commission's
regulations provide adequate safeguards to address this concern. In
this regard, the Commission notes that section 4s(j)(2) of the CEA
requires SDs and MSPs, including CSEs, to establish robust and
professional risk management systems adequate for the management of
their day-to-day swaps business \93\ and that Regulation 23.600,
consistent with the mandate under the CEA, requires SDs and MSPs to
establish and maintain a risk management program to monitor and manage
risk associated with their swap activities.\94\
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\93\ 7 U.S.C. 6s(j)(2).
\94\ See 17 CFR 23.600.
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To obtain relief under Letter 19-29, Cargill also must ``keep track
of exceedances'' \95\ and ``[if] the exceedances indicate that the
Approved IM Calculation Method fails to meet the relevant regulators'
standards, [Cargill] must take appropriate steps to ensure compliance
with its risk management obligations and address exceedances with its
SD counterparty.'' \96\ The purpose of this requirement is to ensure
that Cargill monitors, identifies, and addresses potential shortfalls
in the amount of IM generated by the counterparty. Cargill must also
report to the CFTC ``any adjustments and enhancements . . . applied to
the amount of IM calculated pursuant to the Approved IM Calculation
Method to ensure [Cargill's] collection of adequate amounts of IM.''
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\95\ Exceedances are price movements above the amount of IM
computed using a risk-based model that complies with the
Commission's regulations.
\96\ Letter 19-29 at 4.
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The Commission notes that if a CSE declines to adopt a proprietary
model to calculate IM, a CSE may be unable to verify whether the
amounts of IM calculated by its counterparty are sufficient. The
Commission, however, believes that Regulation 23.600 addresses this
concern by requiring SDs and MSPs to account for credit risk in
conducting their risk oversight and to ensure compliance with the CFTC
margin requirements. In the case of a CSE relying on new paragraph
(a)(5), as adopted, adequate risk oversight will include steps by the
CSE to monitor, identify, and address potential shortfalls in the
amounts of IM generated by the counterparty on whose IM model the CSE
is relying. While the Commission does not prescribe the CSE's oversight
process, it believes that a risk management program that is unable to
identify or to address shortfalls in IM will be insufficient to comply
with Regulation 23.600.
Moreover, Regulation 23.600 requires SDs and MSPs to furnish to the
Commission risk exposure reports setting forth credit risk exposures
and any other applicable risk exposures relating to their swap
activities. Here again, the Commission believes that an adequate risk
exposure report pursuant to Regulation 23.600 will require a CSE to
identify any adjustments and enhancements to the amount of IM
calculated pursuant to the risk-based model of its swap entity
counterparty to ensure the CSE's collection of adequate amounts of IM.
Commenters generally supported the proposed amendment to Regulation
23.154(a) to permit CSEs to rely on their swap entity counterparties'
risk-based model calculation of IM.\97\ A commenter stated that the
proposed alternative method of IM calculation would greatly reduce the
complexity and burden associated with the implementation of the margin
requirements, in particular in the last phases of compliance, thus
fostering greater liquidity and contributing to lowering the hedging
costs of end-users.\98\ Another commenter discussed the competitive
disadvantage that smaller SDs might experience absent the alternative
method of IM calculation.\99\ This commenter noted that large SDs may
be
[[Page 238]]
disincentivized from trading uncleared swaps with such SDs since doing
so would require large SDs to manage risk-based model calculations with
some entities and table-based calculation with smaller SDs.\100\
Further, this commenter stated that table-based IM calculations, which
do not take into account a firm's specific portfolio composition,
including diversification and hedges, might produce more conservative
results requiring the posting and collection of margin that is
inappropriately high given the actual level of risk involved in a
typical transaction.\101\
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\97\ Associations 10/22/2020 Letter at 4; BPEC 10/23/2020 Letter
at 2; FIA 10/22/2020 Letter at 4; STRM 10/23/2020 Letter at 1;
Working Group 10/22/2020 Letter at 3. In addition to the comments
addressing the alternative method of calculation of IM, as proposed,
two commenters requested broadening the Proposal to permit CSEs to
use the risk-based model of calculation of IM of financial end user
counterparties. BPEC 10/23/2020 Letter at 9; Associations 10/22/2020
Letter at 4. In the Commission's view, this matter falls outside the
scope of the Proposal. Accordingly, the Commission will not express
a view or act on this matter.
\98\ BPEC 10/23/2020 Letter at 2.
\99\ FIA 10/22/2020 Letter at 5.
\100\ Id.
\101\ Id. at 5.
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Another commenter representing a group of commercial firms in the
energy industry stated that allowing smaller SDs to rely on their SD
counterparties' approved IM model calculation would allow them to
continue to play a crucial role in certain discrete swaps markets, like
the energy swaps markets, in an economic and cost effective
manner.\102\ The commenter noted that the use of the table-based method
for the calculation of IM by smaller SDs and IM modeling by larger SDs
resulted in a mismatch in calculation methods that could lead to worse
pricing for smaller SDs, as the table-based method would likely cause
their counterparties to post more IM than they would under a model-
based approach, with the cost of that margin being reflected in a
higher price provided to the smaller SDs.\103\
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\102\ Working Group 10/22/2020 Letter at 3.
\103\ Id. See also STRM 10/23/2020 Letter at 2.
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Notwithstanding these expressions of support, many commenters
objected to the provision in the Proposal that limits the application
of the alternative method of calculation of IM to uncleared swaps
entered into by a CSE and a swap entity counterparty to hedge the risk
of customer-facing swaps undertaken by the CSE, namely the hedging
limitation.\104\ A commenter stated that it would be difficult, if not
impossible, to ensure that all transactions to which the alternative
method of calculation could apply are entered into for hedging purposes
given that the concept of hedging is difficult to administer.\105\ The
commenter pointed to questions that may arise, including what standard
should be used to determine whether a given swap is in fact a
``hedge.'' \106\ The commenter asked whether each swap with a large SD
must be matched one-by-one with a swap with a non-swap entity
counterparty,\107\ and whether it would be feasible for an entity to
undertake portfolio hedging or dynamic hedging in that context.\108\
The commenter also asked what would happen if the underlying swap
transaction with a non-swap entity counterparty had been terminated,
and whether anticipatory hedges could be counted as hedging.\109\ The
commenter noted that because the swaps markets are dynamic, the
character of swaps may change over time and tagging a swap as hedging
and non-hedging may be impractical.\110\ The commenter concluded that
given the uncertainty as to what constitutes hedging, CSEs may be
reluctant to apply the alternative method of calculation.\111\
---------------------------------------------------------------------------
\104\ Associations 10/22/2020 Letter at 4; BPEC 10/23/2020
Letter at 2; FIA 10/22/2020 Letter at 6; Working Group 10/22/2020
Letter at 4.
\105\ BPEC 10/23/2020 Letter at 5.
\106\ Id. at 4.
\107\ Id. See also STRM 10/23/2020 Letter at 4 (stating that
classifying individual transactions with other SDs as hedges and
tying the hedges to particular client-facing transactions would
impose a material compliance burden that could nullify any benefit
offered by the relief in proposed Regulation 23.154(a)(5)).
\108\ BPEC 10/23/2020 Letter at 4.
\109\ Id.
\110\ Id.
\111\ Id. at 5.
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Another commenter raised similar concerns regarding difficulties in
applying the concept of hedging, illustrated by the position limits
rule recently adopted after many attempts by the Commission to
implement the Dodd-Frank Act, noting that at the core of the rule lies
the concept of hedging.\112\ The commenter stated that the concept of
hedging is difficult to quantify and that there are many instances when
``hedging'' is virtually indistinguishable from speculation.\113\ In
the absence of a definition in the Final Rule, the commenter stated,
counterparties could be left guessing and may be reluctant to rely on
the alternative method of calculation for fear of violating the hedging
limitation.\114\ A commenter also noted that proposed Regulation
23.154(a)(5) does not define the term hedging and suggested replacing
the term with the phrase ``hedge or mitigate commercial risk.'' \115\
---------------------------------------------------------------------------
\112\ FIA 10/22/2020 Letter at 7.
\113\ Id.
\114\ Id.
\115\ STRM 10/23/2020 Letter at 4.
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Another commenter stated that many CSEs do not separate hedging
from dealing on a transaction-by-transaction basis since CSEs often
manage hedging on a portfolio basis and, as a result, to implement the
hedging limitation, CSEs would need to undertake a significant amount
of analysis and legal review to make hedging determinations, making the
relief provided by the alternative method of IM calculation
impracticable.\116\ Similarly, another commenter stated that if a CSE
must be able to demonstrate that each swap is a hedge of a transaction
with a non-SD, then the CSE would not be able to engage in portfolio
hedging if the portfolio includes risk related to a speculative swap
with another SD.\117\ Consequently, in the commenter's view, the
hedging limitation would limit the flexibility and efficacy of a CSE's
risk management program.\118\
---------------------------------------------------------------------------
\116\ BPEC 10/23/2020 Letter at 5.
\117\ Working Group 10/22/2020 Letter at 4.
\118\ Id.
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In line with these comments, another commenter stated that if a
commercial CSE's portfolio includes non-hedging transactions, the
opportunity to rely on the IM calculations of its SD counterparty may
not be useful since they would need to calculate separately IM for the
non-hedging transactions, which would reduce the benefits of netting or
diversification offered by the Standardized IM Model (``SIMM'').\119\
As a result, the commenter noted, the amount of IM is likely to be
higher, disadvantaging commercial CSEs and their SD counterparties in a
way that would not apply to CSE portfolios with non-SDs.\120\
---------------------------------------------------------------------------
\119\ Associations 10/22/2020 Letter at 4. This commenter, along
with another commenter, also argued that SIMM, whose use must be
approved by a regulator prior to its utilization in the calculation
of regulatory IM, is a robust framework that obviates the need for a
safeguard, such as the hedging limitation, to ensure the calculation
of sufficient amounts of IM. See Associations 10/22/2020 Letter at
5; FIA 10/22/2020 Letter at 9. While recognizing the value of
standardization, the Commission believes that SIMM on its own does
not offer the safeguards necessary to address the concerns raised by
the application of the alternative method of IM calculation. That is
because SIMM is a tool that must be tailored to fit each firm's
portfolio and risk profile, and must be subject to ongoing oversight
to ensure adequate calibration.
\120\ Associations 10/22/2020 Letter at 4.
---------------------------------------------------------------------------
Commenters also noted that CSEs and their counterparties typically
transact both hedging and dealing swaps under a single ISDA Master
Agreement or credit support annex, with many relationships put in place
years ago, and calculate IM at the relationship or master contract
level rather than the transaction level.\121\ A commenter stated that
if CSEs are required to add additional representations confirming that
a given transaction is a ``hedging'' transaction, the existing
documentation would need to be updated.\122\ The commenter further
stated that IM would also need to be administered on the basis of
hedging and non-hedging transactions which would make the
[[Page 239]]
netting of all transactions under a single ISDA Master Agreement
impossible.\123\ As a result, the implementation of the hedging
limitation would be extremely complex and result in potentially added
operational risk, and certain swap entity counterparties, given the
added market and bankruptcy risk, may shy away from undertaking swaps
with CSEs that rely on the alternative method of calculation of
IM.\124\
---------------------------------------------------------------------------
\121\ See generally Associations 10/22/20 Letter at 4; BPEC 10/
23/2020 Letter at 6; FIA 10/22/2020 Letter at 7-8.
\122\ FIA 10/22/2020 Letter at 8.
\123\ Id.
\124\ See Associations 10/22/20 Letter at 4; BPEC 10/23/2020
Letter at 6; FIA 10/22/2020 Letter at 8.
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A commenter also pointed out that having to use the table-based
method of calculation for determining IM in some circumstances and a
counterparty's IM model in other circumstances would be operationally
complex for a CSE, potentially to the point of being unworkable, and
may result in the CSE being forced to choose between entering into
transactions in the inter-dealer market or using the alternative method
of calculation.\125\ The commenter further stated that the hedging
limitation could have negative implications for liquidity in certain
markets, as some CSEs with unique insights and risk profiles that are
best situated to assume customer risk from other SDs may opt not to
trade with such SDs to avoid the burden associated with the hedging
limitation.\126\ Another commenter stated that costs associated with
the hedging limitation, including operational and documentation
burdens, could lead small CSEs to cease providing risk mitigation
services to end-user counterparties, leaving end-users with unhedged
risks.\127\
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\125\ Working Group 10/22/2020 Letter at 4.
\126\ Id. See also STRM 10/23/2020 Letter at 5.
\127\ FIA 10/22/2020 Letter at 8.
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The concerns raised in the foregoing comments hinge on two ideas:
(i) CSEs undertake hedging and speculative swaps with swap entity
counterparties; and (ii) there is no clear standard for determining
which swaps are entered into for hedging purposes. Commenters assert
that because CSEs undertake both hedging and speculative swaps with
swap entity counterparties, the implementation of the hedging
limitation would add further complexity to the transactions and would
be burdensome as swaps are generally managed on a portfolio basis and
may be under a single master netting agreement or credit support annex,
making the separation of hedging and non-hedging transactions
challenging, if not impossible.\128\
---------------------------------------------------------------------------
\128\ See BPEC 10/23/20 Letter at 6; FIA 10/22/2020 Letter at 8.
---------------------------------------------------------------------------
In response to these concerns, the Commission acknowledges the
potential burdens associated with the implementation of the hedging
limitation. However, the Commission points out that the proposed
addition of a method of calculation of IM that would enable a CSE to
rely on a swap entity counterparty's model calculation of IM provides
an alternative to the two existing methods of calculation of IM. The
alternative method provides flexibility to address a particular
situation illustrated in Letter 19-29. As such, it is intended for use
by CSEs whose core swaps business is with non-swap entities but that
occasionally enter into swaps with a few swap entity counterparties to
offset the risk of customer-facing swaps. Given the limited swaps
business with swap entity counterparties, it is uneconomical for the
CSEs to develop, adopt, and maintain a proprietary risk-based model for
the sole purpose of engaging such counterparties.
In light of the intended use for the alternative method of IM
calculation, the Commission incorporated in the Proposal, in line with
Letter 19-29, the hedging limitation restricting the application of the
proposed alternative method of IM calculation to uncleared swaps
entered into by a CSE to hedge the CSE's customer-facing risk. The
Commission noted in the Proposal that the incorporation of the hedging
limitation would also have the effect of limiting the use of the
proposed method of IM calculation. While the proposed alternative
method of IM calculation was intended to make the alternative method
set forth in Letter 19-29 more widely available, the Commission stated
that its application raised some concerns that would be mitigated, in
part, by limiting the use of the alternative method of calculation to
hedging transactions. More specifically, the Commission expressed the
concern that in calculating the amount of IM to be used by the CSE to
determine the amount to be collected from the swap entity counterparty,
the swap entity counterparty could miscalculate the amount of IM or may
be motivated to underestimate the amount of IM in order to post lesser
IM amounts to the CSE. In turn, the CSE, without a proprietary model to
calculate IM, would have no meaningful way to verify whether the
amounts generated by the swap entity counterparty were correct or to
contest the amounts, potentially resulting in the CSE collecting
insufficient amounts of margin to mitigate the risk of its swaps.
The Commission notes that there are other safeguards in the
Commission's regulations, such as risk management requirements
applicable to both CSEs and their swap entity counterparties, that
could address the potential miscalculation or underestimation of IM;
however, the Commission believes that these safeguards do not obviate
the need for the hedging limitation. Rather, in the Commission's view,
the hedging limitation will work together with such other measures to
provide effective protections to address the concerns raised by the
application of the alternative method of calculation of IM.
Accordingly, the Commission has decided to retain the hedging
limitation. The Commission expects that counterparties that engage in
both hedging and speculative transactions would engage in such a small
number of speculative transactions that the complexity and burden of
separating speculative and hedging transactions and operationally
implementing the hedging limitation would be rather low. On the other
hand, if the speculative activity between the CSE and the swap entity
counterparty is so robust as to complicate the use of the alternative
method of calculation, the CSE should be able to carry out its own
calculation of IM by either adopting a proprietary model for the
calculation of margin or using the table-based method of calculation.
It follows that if the CSE adopts a proprietary model of calculation
for its speculative swaps, the CSE should be likewise able to adopt a
model or use the same model for calculating IM for its hedging swaps,
thus obviating the need to rely on its counterparty's IM calculation.
Regarding comments asserting a lack of a clear standard to
differentiate between hedging and non-hedging swaps, the Commission
believes that the existing standard set out in section 4a(c)(2)(B) of
the CEA \129\ to define ``bona fide hedging transaction or position''
provides a suitable framework for determining which swaps are hedges
for the purpose of applying the alternative method of calculation. By
referring to section 4a(c)(2)(B) for this purpose, the Commission is
setting forth a principles-based approach, not requiring strict
adherence to all the terms of the statute, as the statute addresses
physical markets and products not pertinent in this context, and
pertains to issues (i.e., speculation in the physical markets) outside
the scope of this Final Rule. Key principles derived from section
4a(c)(2)(B) that should be taken into account in determining whether a
swap between a CSE and a swap entity counterparty has been entered into
for hedging purposes include: (a) Whether the swap reduces
[[Page 240]]
risk attendant to another swap undertaken between the CSE and a non-
swap entity counterparty; and (b) whether such other swap (i) was
executed by the non-swap entity counterparty as a substitute for
transactions made or to be made, or for positions taken or to be taken
at a later time, in a commercial enterprise; (ii) is economically
appropriate to the reduction of risk in the conduct and management by
the non-swap entity counterparty of a commercial enterprise; and (iii)
arises from the potential change in value of the non-swap entity
counterparty's assets, liability or services. To determine whether the
criteria in (b) above have been satisfied, the CSE, in accordance with
Regulation 23.402(d), would be able to rely on a written representation
from the non-swap entity counterparty, unless the CSE has information
that would cause a reasonable person to question the accuracy of the
representation.\130\
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\129\ 7 U.S.C. 6a(c)(2).
\130\ 17 CFR 23.402(d) (providing that an SD or MSP may rely on
the written representations of a counterparty to satisfy its due
diligence requirements under subpart H of Part 23 of the
Commission's regulations, which sets forth business conduct
standards for SDs and MSPs to be applied in their dealings with
counterparties). See also Position Limits for Derivatives (approved
Oct. 15, 2020) (defining ``bona fide hedging transaction or
position'' to include pass-through swaps, as described in section
4a(c)(2)(B) of the CEA, undertaken to offset the risk of other swaps
entered into to hedge commercial risk, and noting that a
counterparty may rely on its counterparty's written representations
confirming that such counterparty is executing the pass-through swap
to hedge another swap undertaken to offset commercial risk).
---------------------------------------------------------------------------
By using this framework, the Commission believes that many of the
questions raised by the commenters in connection with the application
of the hedging limitation would be addressed. For example, commenters
asked whether swaps entered into by a CSE and an end-user and the
offsetting swaps undertaken by the CSE and a swap entity counterparty
must match one-to-one.\131\ The framework provides some flexibility
permitting CSEs as part of the hedging strategy to match a set of
customer-facing swaps with one or more hedging swaps undertaken with a
swap entity counterparty. Commenters also asked what would happen if
the customer-facing swaps were terminated, and whether anticipatory
hedging would be deemed hedging in the context of the alternative
method of calculation.\132\ Consistent with the framework set forth
above, swaps undertaken by a CSE and a swap entity counterparty as part
of a hedging strategy to offset the risk of customer-facing swaps--
including swaps that are ultimately terminated and swaps that may be
entered into in the future--would be deemed to be hedges for the
purposes of the alternative method of IM calculation.
---------------------------------------------------------------------------
\131\ FIA 10/22/2020 Letter at 7; BPEC 10/23/2020 Letter at 4.
\132\ Id.
---------------------------------------------------------------------------
The Commission confirms, consistent with the statutory framework
set forth in section 4a(c)(2)(B), that both the underlying swap between
the CSE and the end-user counterparty, and the offsetting swap between
the CSE and the swap entity counterparty must be entered into for
hedging purposes. More specifically, the swap between the CSE and the
end-user counterparty must be entered into to hedge risk attendant in a
commercial enterprise. In connection with this position, a commenter
stated that the burden of compliance with the hedging limitation would
be borne not only by the CSE and the swap entity counterparty, but also
by end-users that are counterparties to the CSE, as they too would need
to make an assessment of whether their swaps are for ``hedging''
purposes and would need to update their documentation accordingly.\133\
Given that the alternative method of calculation is expected to be used
in the limited circumstances described herein, the Commission believes
that the chance that end-users may be burdened would be greatly
reduced.
---------------------------------------------------------------------------
\133\ FIA 10/22/2020 Letter at 8.
---------------------------------------------------------------------------
A commenter also stated that the hedging limitation may not only
burden small CSEs but also their swap entity counterparties.\134\
Another commenter noted that a swap entity counterparty may be
reluctant to trade with a CSE fearing the CSE's misrepresentation or
mischaracterization of its swaps as hedges, which could lead the swap
entity counterparty to violate its obligations under the CFTC Margin
Rule.\135\ In this regard, the Commission notes that Regulation
23.402(d) permits a swap entity counterparty with respect to swaps with
a CSE to rely on the CSE's representations to satisfy its due diligence
obligations unless the swap entity counterparty has any reason to
question the CSE's representations.\136\ The Commission believes that
Regulation 23.402(d) mitigates swap entity counterparties' concerns
regarding a CSE's potential misrepresentation or mischaracterization of
its swaps as hedges.
---------------------------------------------------------------------------
\134\ BPEC 10/23/2020 Letter at 5.
\135\ FIA 10/22/2020 Letter at 8.
\136\ See 17 CFR 23.402(d) (allowing SDs or MSPs to rely on the
written representations of a counterparty to satisfy its due
diligence requirements concerning swaps entered into with the
counterparty, unless the SD or MSP has information that would cause
a reasonable person to question the accuracy of the representation).
---------------------------------------------------------------------------
Two commenters suggested replacing the hedging limitation with a
$750 billion threshold, whereby CSEs with AANA below the threshold
would be able to use the alternative method of IM calculation without
imposing conditions on the business of CSEs that could have adverse
market impact.\137\ In the Commission's view, another threshold to
determine the applicability of the CFTC's margin requirements would add
further complexity to the rules. In addition, the Commission believes
that the hedging limitation as adopted and further discussed above is
adequately designed to advance the Commission's goals.
---------------------------------------------------------------------------
\137\ STRM 10/23/2020 Letter at 5; Working Group 10/23/2020
Letter at 5.
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III. Administrative Compliance
A. Regulatory Flexibility Act
The Regulatory Flexibility Act (``RFA'') requires Federal agencies
to consider whether the rules they propose will have a significant
economic impact on a substantial number of small entities.\138\ As
discussed in the Proposal, the amendments being adopted herein only
affect SDs and MSPs that are subject to the CFTC Margin Rule and their
covered counterparties, all of which are required to be eligible
contract participants (``ECPs'').\139\ The Commission has previously
determined that SDs, MSPs, and ECPs are not small entities for purposes
of the RFA.\140\ Therefore, the Commission believes that the Final Rule
will not have a significant economic impact on a substantial number of
small entities, as defined in the RFA.
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\138\ 5 U.S.C. 601 et seq.
\139\ Each counterparty to an uncleared swap must be an ECP, as
the term is defined in section 1a(18) of the CEA, 7 U.S.C. 1a(18)
and Regulation 1.3, 17 CFR 1.3. See 7 U.S.C. 2(e).
\140\ See Registration of Swap Dealers and Major Swap
Participants, 77 FR 2613, 2620 (Jan. 19, 2012) (SDs and MSPs) and
Opting Out of Segregation, 66 FR 20740, 20743 (April 25, 2001)
(ECPs).
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Accordingly, the Chairman, on behalf of the Commission, hereby
certifies pursuant to 5 U.S.C. 605(b) that the Final Rule will not have
a significant economic impact on a substantial number of small
entities.
B. Paperwork Reduction Act
The Paperwork Reduction Act of 1995 (``PRA'') \141\ imposes certain
requirements on Federal agencies, including the Commission, in
connection with their conducting or sponsoring any collection of
information, as defined by the PRA. The
[[Page 241]]
Commission may not conduct or sponsor, and a person is not required to
respond to, a collection of information unless it displays a currently
valid Office of Management and Budget control number. The Final Rule,
as adopted, contains no requirements subject to the PRA.
---------------------------------------------------------------------------
\141\ 44 U.S.C. 3501 et seq.
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C. Cost-Benefit Considerations
Section 15(a) of the CEA requires the Commission to consider the
costs and benefits of its actions before promulgating a regulation
under the CEA.\142\ Section 15(a) further specifies that the costs and
benefits shall be evaluated in light of the following five broad areas
of market and public concern: (1) Protection of market participants and
the public; (2) efficiency, competitiveness and financial integrity of
futures markets; (3) price discovery; (4) sound risk management
practices; and (5) other public interest considerations.
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\142\ 7 U.S.C. 19(a).
---------------------------------------------------------------------------
The Commission is amending the CFTC Margin Rule to revise the
method for calculating AANA for determining whether an FEU has MSE and
the timing of compliance with the IM requirements after the end of the
phased compliance schedule (``timing of post-phase-in compliance'').
These amendments align the CFTC Margin Rule with the BCBS/IOSCO
Framework with respect to these matters. The Commission is also
amending Regulation 23.154(a), consistent with Letter 19-29, to allow
CSEs to use the risk-based model calculation of IM of a counterparty
that is a swap entity.\143\
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\143\ For the definition of the term ``swap entity,'' see supra
note 42.
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With respect to these rule amendments, the Commission considered
the costs and benefits resulting from its discretionary determinations
with respect to section 15(a) considerations, and sought comments from
interested persons regarding the nature and extent of such costs and
benefits. In response to its request for comment, as noted earlier, the
Commission received nine comment letters.\144\ All the comment letters
generally expressed support for the Proposal.\145\ One commenter noted
that it reflects the realities of the marketplace and further aligns
the U.S. regulations with the global regulators.\146\ Other commenters
stated that the Proposal would enable the implementation of the IM
requirements in a practical and efficient manner and reduce the
complexity and burden associated with the implementation of those
requirements.\147\ The commenters added that the Proposal would foster
greater liquidity and contribute to the lowering of hedging costs,
particularly in the last phases of the compliance schedule.\148\
---------------------------------------------------------------------------
\144\ See ACLI 10/23/2020 Letter; Associations 10/22/2020
Letter; BPEC 10/23/2020 Letter; FIA 10/22/2020 Letter; ICI 10/22/
2020 Letter; MFA 10/22/2020 Letter; STRM 10/23/2020 Letter; SIFMA
AMG 10/22/2020 Letter; Working Group 10/22/2020 Letter.
\145\ See ACLI 10/23/2020 Letter at 1; Associations 10/22/2020
Letter at 1; BPEC 10/23/2020 Letter at 2; FIA 10/22/2020 Letter at
2-3; ICI 10/22/2020 Letter at 1; MFA 10/22/2020 Letter at 1; STRM
10/23/2020 Letter at 1; SIFMA AMG 10/22/2020 Letter at 1; Working
Group 10/22/2020 Letter at 3.
\146\ See ACLI 10/23/2020 Letter.
\147\ See generally BPEC 10/23/2020 Letter; MFA 10/22/2020
Letter.
\148\ Id.
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The baseline against which the benefits and costs associated with
the Final Rule is compared is the uncleared swaps markets as they exist
today and the currently applicable timing for compliance with the IM
requirements after the expiration of the phased compliance schedule.
Concerning the amendment to Regulation 23.154(a), the Commission
believes that to the extent market participants may have relied on
Letter 19-29, the actual costs and benefits of the amendment, as
realized by the market, may not be as significant at a practical level.
With respect to the amendments to align aspects of the CFTC Margin Rule
with the BCBS/IOSCO Framework, the Commission notes that the Dodd-Frank
Act calls on the CFTC to ``consult and coordinate on the establishment
of consistent international standards'' with respect to the regulation
of swaps.\149\ The amendments therefore advance the Congressional
direction towards harmonization of the CFTC's requirements with
international standards, thereby removing a regulatory impediment that
might hinder the competitiveness of the U.S. swaps industry.\150\
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\149\ See supra note 79.
\150\ A starting point in determining the potential benefit of
alignment with the BCBS/IOSCO Framework is various statutory
provisions where the U.S. Congress has called on the CFTC and other
financial regulators to align U.S. regulatory requirements with
international standards. For example, the Commodity Futures
Modernization Act of 2000 (``CFMA'') focused on the potential threat
to competitiveness of the U.S. industry where there is divergence
with international standards. In particular, section 126 of the CFMA
provides that regulatory impediments to the operation of global
business interests can compromise the competitiveness of United
States businesses. See CFMA section 126(a), Appendix E of Pub. L.
106-554, 114 Stat. 2763 (2000).
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The Commission notes that the consideration of costs and benefits
below is based on the understanding that the markets function
internationally, with many transactions involving U.S. firms taking
place across international boundaries; with some Commission registrants
being organized outside of the United States; with leading industry
members typically conducting operations both within and outside the
United States; and with industry members commonly following
substantially similar business practices wherever located. Where the
Commission does not specifically refer to matters of location, the
following discussion of costs and benefits refers to the effects of the
Final Rule on all activity subject to the Final Rule, whether by virtue
of the activity's physical location in the United States or by virtue
of the activity's connection with activities in, or effect on, U.S.
commerce under section 2(i) of the CEA.\151\
---------------------------------------------------------------------------
\151\ 7 U.S.C. 2(i).
---------------------------------------------------------------------------
1. Benefits
By harmonizing the CFTC's method for calculating AANA for
determining MSE and the timing of post-phase-in compliance with the
BCBS/IOSCO Framework, the Final Rule will create a benefit because it
will reduce complexity--for example, the month-end AANA calculation
method being adopted will require consideration of only three
observation dates rather than daily AANA averaging over the three-month
calculation period--and the potential for confusion in the application
of the margin requirements. Some entities will no longer need to
undertake separate AANA calculations using different calculation
periods, nor will they need to conform to two separate compliance
timings, varying according to the location of their swap counterparties
and jurisdictional requirements applicable to the counterparties.
The Final Rule will affect FEUs with AANA between $8 billion and
$50 billion that come into the scope of compliance with the IM
requirements under the CFTC Margin Rule in the last compliance phase
beginning on September 1, 2022, as well as those entities that come
into scope after the end of the last compliance phase. The Commission
believes that the Final Rule will benefit some of these entities,
which, given their level of swap activity, pose a lower risk to the
uncleared swaps market and the U.S. financial system in general than
entities that came into scope in earlier phases. The OCE has estimated
that there are approximately 514 of such entities representing 4% of
total AANA across
[[Page 242]]
all phases.\152\ This means that the Final Rule addresses entities that
tend to engage in less uncleared swap trading activity and, and in the
aggregate, pose less systemic risk than entities in previous phases.
Because these entities are smaller, they presumably have fewer
resources to devote to IM compliance and hence will benefit from the
alignment of the method of calculation of AANA across jurisdictions
without contributing substantially to systemic risk.
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\152\ Using March-May of 2020 as the calculation period. The
methodology for calculating AANA is described in Richard Haynes,
Madison Lau, & Bruce Tuckman, Initial Margin Phase 5, at 4 (Oct. 24,
2018), https://www.cftc.gov/sites/default/files/About/Economic%20Analysis/Initial%20Margin%20Phase%205%20v5_ada.pdf.
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For entities with AANA between $8 billion and $50 billion that will
begin collecting IM on September 1, 2022, moving the calculation period
from June, July, and August 2021 to March, April, and May 2022 will
better align with current practices. While the Commission cannot
anticipate exactly how the June-August 2021 period will differ from the
March-May 2022 period, based on comparable past experience, the OCE
estimates that approximately 75-100 entities will come into scope, and
a similar number will fall below the threshold by virtue of moving the
calculation period. The adjusted calculation period will reduce the
regulatory burden for firms that have reduced their MSE below the $8
billion threshold while requiring the collection of margin for those
firms that have increased their swaps business above the threshold.
While aggregate AANA for firms that fall into or out of scope is small
relative to the overall market (less than one percent of total
aggregate AANA), moving the calculation period close to the compliance
date may have a significant impact on entities that have reduced their
MSE.
The Commission also notes that the benefits of alignment with the
BCBS/IOSCO Framework will continue to accrue in future years, as the
determination of MSE for an FEU under the CFTC Margin Rule is an annual
undertaking, triggered by the entry into an uncleared swap between the
FEU and a CSE counterparty and the need to determine whether the FEU
has MSE, which triggers the application of the IM requirements and the
exchange of regulatory IM between a CSE and an FEU for their uncleared
swap transactions.
With respect to the amendment to Regulation 23.154(a), the
Commission believes that the uncleared swap markets will benefit from
the extension of the targeted relief provided to Cargill, the requester
in Letter 19-29, to a wider group of CSEs with similar unique swaps
business models. In taking a no-action position, MPD took account of
Cargill's representation that its swap trading activity primarily
involved physical agricultural commodities and certain other asset
classes and that it ``may maintain positions that require collection of
IM from SDs.'' Cargill further stated that given the highly specialized
and discrete nature of its swaps business, risk-based modeling would
impose a disproportionate burden.
The more widespread availability of the alternative method of
calculation of IM provided by Regulation 23.154(a), as amended by the
Final Rule, may incentivize some market participants to expand their
swaps business. In particular, given that certain market participants
will have the option to forgo the cost of risk-based modeling, this
potential reduction in compliance costs may encourage certain entities
to increase their swaps trading. By increasing the pool of potential
swap counterparties, the Final Rule could enhance competition, increase
overall liquidity, and facilitate price discovery in the uncleared
swaps markets.
2. Costs
While the Final Rule will have the effect of creating efficiencies
for market participants, the Commission acknowledges that the rule
changes being adopted will also give rise to some costs. Among other
things, the change of the CFTC's AANA calculation period for
determining MSE to align it with BCBS/IOSCO's AANA calculation period
will reduce the time frame for determining whether an FEU is subject to
the IM requirements and for preparing for compliance with the
requirements during the final phase-in period of 2022.
Under the current margin requirements, in the period leading to the
final phase-in date of September 1, 2022, FEUs would have a full year
to prepare, as MSE for an FEU would be determined using the AANA for
June, July and August of the prior year. However, under the Final Rule,
entities will have only a three-month advance notice in 2022, as AANA
will be calculated using the March, April and May period of that year.
Entities will have a shorter time frame to engage in preparations to
comply with IM requirements, including, among other things, procuring
rule-compliant documentation, establishing processes for the exchange
of regulatory IM, and setting up IM custodial arrangements. Because the
Final Rule aligns the AANA calculation for determining MSE with BCBS/
IOSCO's approach and the compliance date remains unchanged, the
Commission believes that the cost will be mitigated. In particular, the
Commission notes that commenters confirmed,\153\ as reported in the
Margin Subcommittee Report, that the differences in the U.S.
regulations could create complexity and confusion and lead to
additional effort, cost and compliance challenges for smaller market
participants that are generally subject to margin requirements in
multiple global jurisdictions.\154\
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\153\ See ACLI 10/23/2020 Letter at 2; Associations 10/22/2020
Letter at 3; FIA 10/22/2020 Letter at 4; SIFMA AMG 10/22/2020 Letter
at 3; Working Group 10/22/2020 Letter at 2.
\154\ Margin Subcommittee Report at 49.
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The Commission further notes that the amendment to the timing of
post-phase-in compliance, as proposed, will defer compliance with the
IM requirements with respect to uncleared swaps entered into by a CSE
with an FEU that comes into the scope of IM compliance after the end of
the last compliance phase. Under the current rule being amended, FEUs
with MSE as measured in June, July, and August 2022 would have come
into the scope of compliance post-phase-in beginning on January 1,
2023. On the other hand, under the Final Rule, FEUs with MSE as
measured in March, April, and May 2023 will come into scope, post-
phase-in compliance, beginning on September 1, 2023. As a result, for
FEUs with MSE in both periods, less collateral for uncleared swaps may
be collected given that the Final Rule changes the beginning of post-
phase-in compliance from January 1, 2023, to September 1, 2023,
rendering uncleared swap positions entered into between January 1,
2023, and September 1, 2023, riskier, as no IM will be required to be
collected during that period, which could increase the risk of
contagion and the potential for systemic risk. The Commission, however,
notes that under the Final Rule, a CSE may be required to exchange IM
with an FEU that comes into scope in the last phase of compliance
beginning on September 1, 2022, but falls below the MSE level by
January 1, 2023, for nine months longer than otherwise would have been
the case, as post-phase-in, no assessment of MSE status will be
required until September 1, 2023.
With respect to the adoption of a month-end AANA methodology for
the calculation of AANA for determining MSE, as proposed, the
Commission acknowledges that there are potential costs. The utilization
of month-end
[[Page 243]]
AANA could result in an AANA calculation that is not representative of
a market participant's participation in the swaps markets. As
previously discussed, an AANA calculation based on month-end AANA may
result in the exclusion or undercounting of certain financial contracts
that are required to be included in the calculation (e.g., uncleared
swaps, uncleared security-based swaps, foreign exchange forwards, or
foreign exchange swaps) because of certain combinations of tenure and
time of execution, such as those often present in some intra-month
natural gas and electricity swaps.\155\ The Commission also notes the
potential that market participants might ``window dress'' their
exposures to avoid MSE status and compliance with the CFTC's margin
requirements. At the same time, it is possible that the month-end
methodology, which uses only three data points, could result in some
entities having an AANA calculation on the three end-of-month dates
that is uncharacteristically high relative to their typical positions.
---------------------------------------------------------------------------
\155\ See supra note 59.
---------------------------------------------------------------------------
If products are excluded from the AANA calculation, or if exposures
are ``window dressed,'' the month-end calculation may have the effect
of deferring the time by which market participants meet the MSE
classification resulting in additional swaps between market
participants and CSEs being deemed legacy swaps that are not subject to
the IM requirements.\156\ This may increase the level of counterparty
credit risk to the financial system. While potentially meaningful, this
risk will be mitigated because the legacy swap portfolios will be
entered into with FEUs that engage in lower levels of notional trading.
---------------------------------------------------------------------------
\156\ For explanation of legacy swaps, see supra note 49.
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In addition, many larger SDs are under the jurisdiction of the U.S.
prudential regulators, and these entities and their counterparties will
apparently be required to continue to use the current AANA calculation
methodology. Entities that trade with both SDs that are under the
jurisdiction of the U.S. prudential regulators and CSEs that are under
the CFTC's jurisdiction will be required to undertake separate AANA
calculations using different calculation periods, varying according to
the regulator of their swap counterparty. Hence, entities that trade in
other jurisdictions and that trade with SDs subject to the prudential
regulators' jurisdiction will be required to continue to undertake
separate AANA calculations using different calculation periods and two
separate compliance timings. In fact, an entity that only trades in the
U.S. will now be required to conduct separate AANA calculations using
different calculation periods and timings. While we received no
quantification of the number of such entities, SDs regulated by U.S.
prudential regulators represent a sizable share of swap trading.
Recognizing the potential for costs to increase for this reason,
all of the comments received by the Commission noted the benefits of
alignment with the BCBS/IOSCO Framework, and none mentioned the costs
associated with any potential misalignment with the U.S. prudential
regulators. Further, some commenters stated that the CFTC should
proceed with the amendments even if the prudential regulators do not
make corresponding changes to their margin rules.\157\
---------------------------------------------------------------------------
\157\ SIFMA AMG 10/22/2020 Letter at 3; Working Group 10/22/2020
Letter at 2.
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In addition, the Commission notes that, in the aforementioned OCE
exercise utilizing a sample of days, the OCE estimated that
calculations based on end-of-month AANA would yield fairly similar
results as the calculations based on the current daily average AANA
approach (setting aside the window dressing issue). Based on 2020 swap
data, the OCE estimated that approximately 492 entities of the 514
entities that would have come into scope in the last phase of the
phased compliance schedule, based on the existing methodology, would
also come into scope based on the methodology being adopted under the
Final Rule. Put differently, all but 22 of the entities that would be
above MSE under the existing methodology would also be above MSE under
the Final Rule's methodology. In addition, there are 20 entities that
would be in scope under the Final Rule's methodology, but would not
have been under the existing methodology, so that the aggregate number
of entities differs only by two. In aggregate, the two methodologies
capture quite similar sets of entities. In addition, the entities that
fall out of scope when one changes methodology tend to be among the
smallest of entities coming into scope in the last phase of compliance.
That is, entities that would have been in-scope under the current
methodology but not the Final Rule's methodology average $6.95 billion
in AANA, compared to $20 billion for all entities coming into scope in
the last phase of compliance.\158\
---------------------------------------------------------------------------
\158\ See supra note 60.
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Taking account of the relatively small percentage of aggregate AANA
represented by FEUs that will have MSE for the first time in the near
future, and thus be subject to the Commission's IM requirements under
the Final Rule, the Commission believes that the potential exclusion of
certain financial products in determining MSE will have a limited
impact on the effectiveness of the CFTC Margin Rule. In addition, with
respect to the potential that a market participant might ``window
dress'' its exposure, the Commission believes that the anti-evasion
language being incorporated into the rule text by this Final Rule,
discussed in more detail above, would reduce the risk that swap
exposures or positions might be manipulated to evade the CFTC's IM
requirements. The Commission also notes that it has authority,
including anti-fraud authority under section 4b of the CEA,\159\ to
take appropriate enforcement actions against any market participant
that may engage in deceptive conduct with respect to the AANA
calculation, and that CSEs, under the Commission's regulations, must
have written policies and procedures in place to prevent evasion or the
facilitation of an evasion by an FEU counterparty.\160\
---------------------------------------------------------------------------
\159\ 7 U.S.C. 6b.
\160\ See 17 CFR 23.402(a)(ii).
---------------------------------------------------------------------------
Roughly 514 entities, as estimated by the OCE, will come into the
scope of the IM requirements beginning on September 1, 2022, and will
be affected by the Final Rule. In advance of the September 1, 2022
compliance date, many of these entities may have engaged in planning
and preparations relating to the exchange of regulatory IM. With the
revision of the AANA method of calculation, these entities may need to
adjust their systems to reflect changes in the calculation and update
related financial infrastructure arrangements. However, the Commission
believes that the resulting increased costs will be negligible, and the
amendments being adopted will likely be cost-reducing for those
impacted firms.
Regarding the amendment to Regulation 23.154(a), there may be
associated costs, as CSEs will be able to rely on the risk-based model
calculation of IM computed by a swap entity counterparty. The safeguard
provided by the requirement that both the CSE and its SD counterparty
maintain a risk-based IM model for any swap transaction for which they
do not use the table-based method to calculate IM will be eliminated. A
CSE that relies on a counterparty's risk-based model calculations may
forgo the adoption of a risk-based model and thus avoid the rigorous
Commission requirements
[[Page 244]]
relating to risk-based modeling,\161\ which may undercut the
effectiveness of the CSE's risk oversight.\162\
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\161\ See generally 17 CFR 23.154(b).
\162\ But cf. 17 CFR 23.600 (requiring SDs and MSPs to establish
a robust risk management program for the monitoring and management
of their swap activities).
---------------------------------------------------------------------------
In addition, the safeguard of private market discipline that is
inherent in having each counterparty develop its own IM model, and
therefore the ability for the parties to scrutinize each other's IM
model and output, will not be present given that under the Final Rule,
a CSE will be permitted to rely on the risk-based model calculation of
a swap entity counterparty. As such, there is the potential that
insufficient amounts of IM will be generated by the swap entity
counterparty, which may be attributable to a deficiency in the model or
the fact that the swap entity may be inherently conflicted and
interested in generating lower IM collectable by the CSE.\163\ Without
a model, the CSE will lack adequate means to verify the amount of IM
produced by the swap entity counterparty and will not be capable to
contest it. As a result, insufficient amounts of IM may be collected by
the CSE to protect itself against the risk of default by the swap
entity counterparty, increasing the risk of contagion and the potential
for systemic risk.
---------------------------------------------------------------------------
\163\ But cf. 17 CFR 23.600 (requiring swap entities to have a
risk management program for the management and monitoring of risk
associated with their swaps, which may reduce the risk that such
entities may act in a conflicted manner).
---------------------------------------------------------------------------
The Commission, however, believes that these costs are mitigated by
the Final Rule, because it reflects the narrow terms of Letter 19-29,
which extends no-action relief only with respect to uncleared swaps
entered into for the purpose of hedging. In addition, the Commission
notes that there are other requirements in the Commission's regulations
that address the monitoring of exposures and swap risk.
3. Section 15(a) Considerations
In light of the foregoing, the CFTC has evaluated the costs and
benefits of the Final Rule pursuant to the five considerations
identified in section 15(a) of the CEA as follows:
(a) Protection of Market Participants and the Public
The Final Rule aligns the CFTC's method for calculating AANA for
determining MSE and the timing of post-phase-in compliance with the
BCBS/IOSCO Framework. By aligning these aspects of the CFTC Margin Rule
with the international standard, the Final Rule will reduce the
potential for complexity and confusion that can result from using
different AANA calculation methods and different compliance schedules
for some market participants that may be subject to margin requirements
in multiple jurisdictions, which could result in errors in determining
whether a particular entity comes within the scope of the CFTC Margin
Rule, and, in turn, the failure to exchange requisite margin if the
entity is mistakenly determined to be out of scope.
The Final Rule may result in FEUs having less time between the
calculation of AANA to determine whether they reach the MSE level, and
the date on which CSEs would be required to exchange IM with the FEUs
should the FEUs reach the MSE level. This may make it more difficult
for such FEUs to prepare for the exchange of IM for their uncleared
swaps with CSEs and to timely post IM, increasing the risk of their
swap positions.
More specifically, under the existing CFTC Margin Rule, beginning
on September 1, 2022, FEUs would have been required to look back to the
June-August 2021 period to determine whether they have MSE and come
within the scope of the IM requirements. The firms would have had at
least twelve months to engage in preparations for the exchange of
regulatory IM, by, among other things, procuring rule-compliant
documentation, establishing processes and systems for the calculation,
collection and posting of IM collateral, and setting up custodial
arrangements. Under the Final Rule, which changes the AANA calculation
period for determining MSE to March-May of the current year, such firms
will have only a three-month window to engage in preparations to
exchange IM. Nevertheless, the Commission notes that, under the current
rule being amended, after the end of the phased compliance schedule,
firms would have had only four months in subsequent years between
calculation and required compliance since the calculation period for
determining MSE status would have been June through August of the prior
year, with compliance starting January 1 of the following year. In
addition, because the Final Rule requires the averaging of three month-
end dates rather than all business days during the three-month
calculation period, the potential burdens of a shorter preparatory
period may be offset by the adoption of the BCBS/IOSCO Framework's less
onerous calculation method for some entities.
Moreover, the Final Rule shifts the timing of post-phase-in
compliance to September 1 of each year. As such, some entities that
otherwise would have been required to exchange IM beginning January 1,
2023, will be able to defer compliance to September 1, 2023.\164\ As a
result, less collateral for uncleared swaps may be collected between
January 1, 2023, and September 1, 2023, rendering the parties'
positions riskier during that nine-month period, which could raise the
risk of contagion and increase the potential for systemic risk. Firms
that would have fallen out of scope by January 1, 2023, will also be
subject to compliance for an additional nine months.
---------------------------------------------------------------------------
\164\ This would apply to entities that meet the MSE level based
on their AANA during the June, July, and August 2022 period, and
continue to have MSE in the March, April, and May 2023 period. Of
course, changing the calculation period to the March, April, and May
2023 period may lead to the inclusion of entities whose AANA is
below MSE in the June, July, and August 2022 period, but rises to
the MSE level or above by the March, April, and May 2023 period. The
OCE estimated that approximately 75-100 entities typically move from
one side of the MSE threshold to the other between measurement
periods.
---------------------------------------------------------------------------
The amendment to Regulation 23.154(a), as proposed, will allow a
CSE to use the risk-based model calculation of IM of a counterparty
that is a swap entity. As a result, the CSE may forgo the adoption of a
risk-based model, avoiding the cost and burden associated with the
development and maintenance of a model. Without a model, the CSE may
not be able to challenge the amounts generated by the swap entity
counterparty, which may be insufficient because of model error or
malfunction or because the swap entity, given the inherent conflict of
interest, may be biased in favor of calculating and posting lower
amounts of IM to the CSE. Hence, the CSE may collect insufficient
amounts of IM to offset the risk of counterparty default, increasing
the risk of contagion and the potential for systemic risk.
The Commission believes that these risks may be mitigated by the
Final Rule, which is narrowly tailored to permit reliance on a swap
entity counterparty's risk-based model calculation only with respect to
uncleared swaps entered into for the purpose of hedging. In addition,
Regulation 23.600, which requires SDs and MSPs to adopt a robust risk
management program for the monitoring and management of risk related to
their swap activities, imposes an additional safeguard by requiring the
monitoring of exposures and swap risk.
[[Page 245]]
(b) Efficiency, Competitiveness, and Financial Integrity of Markets
The Final Rule aligns the CFTC Margin Rule's AANA calculation
method for determining MSE and the timing of post-phase-in compliance
with the BCBS/IOSCO Framework. The Final Rule will thus reduce the
need, at least for entities not also undertaking swaps with U.S.
prudentially regulated SDs, to undertake separate AANA calculations
accounting for different calculation methods and to conform to separate
compliance timings, varying according to the location of swap
counterparties and jurisdictional requirements applicable to the
counterparties.\165\ As such, the Final Rule may promote market
efficiency and may level the playing field for CSEs, fostering
competitiveness and reducing the incentive for market participants to
engage in regulatory arbitrage by identifying more accommodating margin
frameworks.
---------------------------------------------------------------------------
\165\ As noted above, for entities that only trade in the U.S.,
the Final Rule may result in separate compliance timings and AANA
calculations.
---------------------------------------------------------------------------
The amendment to Regulation 23.154(a), as proposed, will allow CSEs
to rely on a swap entity counterparty's IM risk-based model
calculation. This will generally result in lower IM than if IM were
calculated using the standardized IM table. As such, the amendment may
allow CSEs to more effectively compete in providing swaps to end-users.
The Final Rule may thus promote efficiency in the uncleared swaps
market by increasing the pool of swap counterparties and fostering
competition.
Potential costs may arise because, without its own model, a CSE may
lack effective means to verify its counterparty's IM calculations. As a
result, if there are shortfalls in the output, the CSE may collect less
IM collateral to offset the risk of default by the counterparty, which
could increase the risk of contagion, threatening the integrity of the
U.S. financial markets. The Commission, however, believes that the
Final Rule is sufficiently targeted to mitigate these risks. The Final
Rule will apply only when uncleared swaps are entered into for hedging,
thus limiting widespread use and the potential for uncollateralized
uncleared swap risk.
(c) Price Discovery
By aligning the CFTC Margin Rule and the BCBS/IOSCO Framework with
respect to the AANA calculation method for determining MSE and the
post-phase-in compliance timing, the Final Rule may reduce the burden
and confusion inherent in implementing separate measures and processes
to address compliance in different jurisdictions for some entities. The
Final Rule may thus incentivize more firms to enter into uncleared swap
transactions, increasing liquidity and leading to more robust pricing
that reflects market fundamentals.
The amendment to Regulation 23.154(a), as proposed, may relieve
certain CSEs from having to adopt a risk-based margin model to
calculate IM or use the standardized IM table, by allowing them to rely
on a counterparty's risk-based model calculation of IM. Relative to the
alternatives, being able to have IM calculated in this manner may lower
the costs of trading for such entities, and they may increase their
trading in uncleared swaps, which in turn may increase liquidity and
enhance price discovery. On the other hand, the Final Rule may
encourage entities to shift their trading from swaps that can be
cleared, potentially reducing liquidity and price discovery in those
markets.
(d) Sound Risk Management
The Final Rule may reduce the need for some firms to undertake
separate AANA calculations using different methods and to conform to
separate compliance timing, allowing firms to engage in sound risk
management by focusing on more substantive requirements.
Under the current rule, after the last phase of compliance, CSEs
that enter into uncleared swaps with FEUs with MSE would have been
required to exchange IM with such FEUs beginning on January 1, 2023.
Under the Final Rule, CSEs will not be required to exchange IM with an
FEU with MSE until September 1, 2023. As such, one effect of adopting
the Final Rule is that uncleared swaps entered into between January 1,
2023, and September 1, 2023, by a CSE and FEU with MSE may now be
uncollateralized. Given that less collateral may be collected during
that nine-month period, positions created during that period may be
riskier, increasing the risk of contagion and systemic risk.
Conversely, because the existing January 1, 2023 compliance date would
have required reassessment of MSE status on such date, certain FEUs
that came into scope in the last phase of compliance may have come out
of scope post-phase-in, resulting in the collection of less collateral
for such entities than under the Final Rule. The Commission therefore
believes that balancing the additional firms that will not be required
to exchange IM until September 2023, against the possibility that some
firms would have come out of scope under the existing requirements, the
impact of the rule change with respect to the exchange of required
collateral is likely to be relatively small.
Also, it is possible that FEUs trading certain financial products
may not meet the MSE threshold because month-end positions in these
financial products are not reflective of their typical position, so
that their month-end AANAs may be uncharacteristically low.\166\ As
result, CSEs and such FEUs may not exchange IM for their uncleared
swaps and their swaps may be insufficiently collateralized, increasing
the risk of contagion and systemic risk. Conversely, because more than
96% of FEUs are unlikely to have MSE and come within the scope of the
IM requirements, as estimated by the OCE, the exclusion of such
products will have a limited impact on the effectiveness of the
Commission's IM requirements.
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\166\ As noted in footnote 60 infra, the month-end calculation
may tend to undercount positions in certain physical energy swaps.
---------------------------------------------------------------------------
Having only three observations to evaluate an entity's typical
position may lead to less precision in determining which entities are
most likely to contribute to systemic risk. However, absent ``window
dressing'' issues, the effect of having fewer observations is unlikely
to be substantial. Based on 2020 trading, OCE estimates that the sets
of firms that will meet MSE under either measure are largely the same,
and the set of entities that meet one criterion and not the other tends
to consist of the smallest entities.
In regard to ``window dressing,'' AANA calculations based on month-
end AANA compared to the currently required daily AANA averaging may be
more susceptible to manipulation and less conducive to sound risk
management. FEUs may manage their exposures as they approach the month-
end date during the three-month calculation period to avoid MSE status.
The Commission, however, believes that the anti-evasion language being
incorporated into the rule text by this Final Rule, discussed in more
detail above, would reduce the risk of window dressing. In addition,
the Commission notes that it has authority, including anti-fraud
authority under section 4b of the CEA, to take appropriate enforcement
actions against any market participant that may engage in deceptive
conduct with respect to the AANA calculation, and that CSEs, under the
Commission's regulations, must have written policies and procedures in
place
[[Page 246]]
to prevent evasion or the facilitation of an evasion by an FEU
counterparty.\167\
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\167\ See 17 CFR 23.402(a)(ii).
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As proposed, the Final Rule allows CSEs to use the risk-based model
calculation of a swap entity counterparty to calculate the amount of IM
to be collected from such counterparty, consistent with Letter 19-29.
As a result, CSEs may no longer be incentivized to adopt a proprietary
risk-based model. If a CSE uses a counterparty's IM model calculation
without developing its own model, the CSE may lack reasonable means to
verify the IM provided by its counterparty, recognize shortfalls in the
IM calculation, and identify potential flaws in the swap entity
counterparty's risk-based model. As such, insufficient amounts of IM
may be collected by the CSE to protect itself against the risk of
default by the swap entity counterparty, increasing the risk of
contagion and the potential for systemic risk. The Commission, however,
believes that these risks are mitigated because, under the Final Rule,
CSEs are able to use a counterparty's risk-based model IM calculation
only with respect to uncleared swaps entered into for the purpose of
hedging. In addition, the Commission notes that there are other
requirements in the Commission's regulations that address the
monitoring of exposures and swap risk.
(e) Other Public Interest Considerations
The Commission believes that the Final Rule, by aligning the CFTC
Margin Rule with the BCBS/IOSCO Framework, will promote harmonization
with international regulatory requirements and may reduce the potential
for regulatory arbitrage. However, given that the U.S. prudential
regulators have not amended their margin requirements in line with the
Final Rule, the possibility exists that certain firms may undertake
swaps with particular SDs based on which U.S. regulatory agency is
responsible for setting margin requirements for such SDs.
D. Antitrust Laws
Section 15(b) of the CEA requires the Commission to take into
consideration the public interest to be protected by the antitrust laws
and endeavor to take the least anticompetitive means of achieving the
objectives of the CEA, as well as the policies and purposes of the CEA,
in issuing any order or adopting any Commission rule or regulation
(including any exemption under section 4(c) or 4c(b)), or in requiring
or approving any bylaw, rule or regulation of a contract market or
registered futures association established pursuant to section 17 of
the CEA.\168\
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\168\ 7 U.S.C. 19(b).
---------------------------------------------------------------------------
The Commission believes that the public interest to be protected by
the antitrust laws is generally to protect competition. The Commission
requested comment on whether the Proposal implicated any other specific
public interest to be protected by the antitrust laws and received no
comments.
The Commission has considered the Final Rule to determine whether
it is anticompetitive, and has identified no anticompetitive effects.
The Commission requested comment on whether the Proposal was
anticompetitive and, if it was, what the anticompetitive effects were,
and received no comments.
Because the Commission has determined that the Final Rule is not
anticompetitive and has no anticompetitive effects, the Commission has
not identified any less competitive means of achieving the purposes of
the Act.
List of Subjects in 17 CFR Part 23
Capital and margin requirements, Major swap participants, Swap
dealers, Swaps.
For the reasons stated in the preamble, the Commodity Futures
Trading Commission amends 17 CFR part 23 as follows:
PART 23--SWAP DEALERS AND MAJOR SWAP PARTICIPANTS
0
1. The authority citation for part 23 continues to read as follows:
Authority: 7 U.S.C. 1a, 2, 6, 6a, 6b, 6b-1, 6c, 6p, 6r, 6s, 6t,
9, 9a, 12, 12a, 13b, 13c, 16a, 18, 19, 21.
Section 23.160 also issued under 7 U.S.C. 2(i); Sec. 721(b),
Pub. L. 111-203, 124 Stat. 1641 (2010).
0
2. In Sec. 23.151, revise the definition of ``Material swaps
exposure'' to read as follows:
Sec. 23.151 Definitions applicable to margin requirements.
* * * * *
Material swaps exposure for an entity means that, as of September 1
of any year, the entity and its margin affiliates have an average
month-end aggregate notional amount of uncleared swaps, uncleared
security-based swaps, foreign exchange forwards, and foreign exchange
swaps with all counterparties for March, April, and May of that year
that exceeds $8 billion, where such amount is calculated only for the
last business day of the month. Activities not carried out in the
regular course of business and willfully designed to circumvent
calculation at month-end to evade meeting the definition of material
swaps exposure shall be prohibited. An entity shall count the average
month-end aggregate notional amount of an uncleared swap, an uncleared
security-based swap, a foreign exchange forward, or a foreign exchange
swap between the entity and a margin affiliate only one time. For
purposes of this calculation, an entity shall not count a swap that is
exempt pursuant to Sec. 23.150(b) or a security-based swap that
qualifies for an exemption under section 3C(g)(10) of the Securities
Exchange Act of 1934 (15 U.S.C. 78c-3(g)(4)) and implementing
regulations or that satisfies the criteria in section 3C(g)(1) of the
Securities Exchange Act of 1934 (15 U.S.C. 78-c3(g)(4)) and
implementing regulations.
* * * * *
0
3. In Sec. 23.154, add paragraph (a)(5) to read as follows:
Sec. 23.154 Calculation of initial margin.
(a) * * *
(5) A covered swap entity would be deemed to calculate initial
margin as required by paragraph (a)(1) of this section if it uses the
amount of initial margin calculated by a counterparty that is a swap
entity and the initial margin amount is calculated using the swap
entity's risk-based model that meets the requirements of paragraph (b)
of this section or is approved by a prudential regulator, provided that
initial margin calculated in such manner is used only with respect to
uncleared swaps entered into by the covered swap entity and the swap
entity for the purpose of hedging the covered swap entity's swaps with
non-swap entity counterparties.
* * * * *
Issued in Washington, DC, on December 11, 2020, by the
Commission.
Christopher Kirkpatrick,
Secretary of the Commission.
Note: The following appendices will not appear in the Code of
Federal Regulations.
Appendices to Margin Requirements for Uncleared Swaps for Swap Dealers
and Major Swap Participants--Commission Voting Summary and
Commissioners' Statements
Appendix 1--Commission Voting Summary
On this matter, Chairman Tarbert and Commissioners Quintenz,
Behnam, Stump, and Berkovitz voted in the affirmative. No
Commissioner voted in the negative.
[[Page 247]]
Appendix 2--Statement of Support of Commissioner Brian D. Quintenz
I vote in favor of today's final rule that first, amends a key
definition used to determine whether a financial end-user must
comply with the Commission's uncleared swap margin regulations when
trading with a swap dealer,\1\ and second, codifies no-action relief
providing additional flexibility for swap dealers to use the risk-
based calculation of initial margin.\2\ With regard to the
adjustment to the definition of material swap exposure, I support
the fact that the rulemaking further aligns the Commission's rules
to the framework agreed upon by the international framework
established by BCBS-IOSCO. However, I continue to take issue with
the reliance on notional value as the defining metric for
determining whether a firm should be subject to the uncleared margin
regulations. The philosophy behind such a framework is that firms
with small levels of swaps can have outsized impacts on the
financial system. Further, the fact that we, as an agency and as
international regulators, continue to embrace a metric as useless,
biased, and arbitrary as notional value is something I have long
opposed, and I have never, not once, heard an acceptable or even
rationale defense for doing so.
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\1\ Definition of material swap exposure under reg. 23.151(a).
\2\ CFTC Letter 19-29.
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Appendix 3--Statement of Support of Commissioner Dawn D. Stump Overview
I am pleased to support the final rulemaking that the Commission
is adopting with respect to the definition of ``material swaps
exposure'' and an alternative margin calculation method in
connection with the Commission's margin requirements for uncleared
swaps.
This rulemaking addresses recommendations that the Commission
has received from its Global Markets Advisory Committee (``GMAC''),
which I am proud to sponsor, and is based on a comprehensive report
prepared by GMAC's Subcommittee on Margin Requirements for Non-
Cleared Swaps (``GMAC Margin Subcommittee'').\1\ It demonstrates the
value added to the Commission's policymaking by its Advisory
Committees, in which market participants and other interested
parties come together to provide us with their perspectives and
potential solutions to practical problems.
---------------------------------------------------------------------------
\1\ Recommendations to Improve Scoping and Implementation of
Initial Margin Requirements for Non-Cleared Swaps, Report to the
CFTC's Global Markets Advisory Committee by the Subcommittee on
Margin Requirements for Non-Cleared Swaps (April 2020) (``Margin
Subcommittee Report''), available at https://www.cftc.gov/media/3886/GMAC_051920MarginSubcommitteeReport/download.
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The rulemaking we are adopting makes two changes to the
Commission's uncleared margin rules. These changes have much to
commend them--indeed, we did not receive any comment letters
opposing them. These rule changes further objectives that I have
commented on before:
The imperative of harmonizing our margin requirements
with those of our international colleagues in order to facilitate
compliance and coordinated regulatory oversight; and
the benefits of codifying relief that has been issued
by our Staff and re-visiting our rules, where appropriate.
Background: A Different Universe Is Coming Into Scope of the Uncleared
Margin Rules
The Commission's uncleared margin rules for swap dealers, like
the Framework of the Basel Committee on Banking Supervision and the
Board of the International Organization of Securities Commissions
(``BCBS/IOSCO'') \2\ on which they are based, were designed
primarily to ensure the exchange of margin between the largest, most
systemic, and interconnected financial institutions for their
uncleared swap transactions with one another. Today, these
institutions and transactions are subject to uncleared margin
requirements that have taken effect since the rules were adopted.
---------------------------------------------------------------------------
\2\ See generally BCBS/IOSCO, Margin requirements for non-
centrally cleared derivatives (July 2019), available at https://www.bis.org/bcbs/publ/d475.pdf.
---------------------------------------------------------------------------
Pursuant to the phased implementation schedule of the
Commission's rules and the BCBS/IOSCO Framework, though, a different
universe of market participants--presenting unique considerations--
will soon be coming into scope of the margin rules. It is only now,
as we enter the final phases of the implementation schedule, that
the Commission's uncleared margin rules will apply to a significant
number of financial end-users, and we have a responsibility to make
sure they are fit for that purpose. Accordingly, now is the time we
must thoughtfully consider whether the regulatory parameters that we
have designed for the largest financial institutions in the earlier
phases of margin implementation need to be tailored to account for
the practical and operational challenges posed by the exchange of
margin when one of the counterparties is a pension plan, endowment,
insurance provider, mortgage service provider, or other financial
end-user.
International Harmonization To Enhance Compliance and Coordinated
Regulation
The first rule change we are adopting would revise the
calculation method for determining whether financial end-users come
within the scope of the initial margin (``IM'') requirements, and
the timing for compliance with the IM requirements after the end of
the phased compliance schedule. These changes would align certain
timing and calculation issues under the Commission's margin rules
with both the BCBS/IOSCO Framework and the manner in which these
issues are handled by our regulatory colleagues in all other major
market jurisdictions.
Swap dealers must exchange IM with respect to uncleared swaps
that they enter into with a financial end-user counterparty that has
material swaps exposure (``MSE''). The Commission's margin rules
currently provide that after the last phase of compliance, MSE is to
be determined on January 1, and that an entity has MSE if it has
more than $8 billion in average aggregate notional amount (``AANA'')
during June, July, and August of the prior year. By contrast, under
the BCBS/IOSCO Framework and in virtually every other country in the
world, an entity is determined to come into scope of the IM
requirement on September 1, and an entity has MSE if it has the
equivalent of $8 billion in AANA \3\ during March, April, and May of
that year.
---------------------------------------------------------------------------
\3\ The MSE threshold under the BCBS/IOSCO Framework is stated
in euros rather than dollars.
---------------------------------------------------------------------------
The reason the United States is out-of-step with the rest of the
world on these timing and calculation issues is not because of any
reasoned policy determination. Rather, it is the result of a quirk
that the U.S. margin rules were adopted based on the BCBS/IOSCO
Framework that was in effect at the time--but the BCBS/IOSCO
Framework was revised two years later.
In a further disconnect, the Commission's margin rules look to
the daily average AANA during the three-month calculation period for
determining MSE, whereas the BCBS/IOSCO Framework and other major
market jurisdictions base the AANA calculation on an average of
month-end dates during that period. Yet, as noted in the rulemaking
release, the Commission's Office of the Chief Economist has
estimated that calculations based on end-of-month AANA generally
would yield similar results as calculations based on the
Commission's current daily AANA approach. It has been suggested that
this rule change theoretically might incentivize a firm to ``window
dress'' its swap exposures as the month-end approaches in order to
avoid margin requirements. But the GMAC Margin Subcommittee observed
that it would be neither practicable nor financially desirable for
parties to tear-up their positions on a recurring basis prior to the
month-end calculation,\4\ because doing so would interfere with
hedging strategies and cause the firm to incur realized profit and
loss.\5\
---------------------------------------------------------------------------
\4\ Margin Subcommittee Report at 52.
\5\ Commenters made this same point. See, e.g., Joint Letter
from ISDA, SIFMA, and GFXD at 3 (month-end window dressing is not a
realistic risk since unwinding and then reestablishing positions on
a recurring basis over the three-month period would take
considerable effort, interrupt hedging strategies, and require
counterparties to absorb the costs of realized profit and loss
changes); Letter from SIFMA Asset Management Group at 3 (it would be
neither practicable nor financially desirable for parties to tear-up
positions on a recurring basis prior to each month end); Letter from
Investment Company Institute at 5-6 (for regulated funds, adjusting
swap exposures over the course of three periodic dates solely to
avoid IM could impose transaction costs and inhibit a fund's ability
to manage its portfolio risk, which may be inconsistent with the
investment adviser's fiduciary duty to act in the best interest of
its client). Comment letters available at https://comments.cftc.gov/PublicComments/CommentList.aspx?id=4157.
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Accordingly, the Commission is amending these timing and
calculation provisions of its uncleared margin rules to harmonize
them with the BCBS/IOSCO Framework and the approach followed by our
international colleagues. Given the global nature of the derivatives
markets, we should always seek international harmonization of our
[[Page 248]]
regulations unless a compelling reason exists not to do so--which is
not the case here.
Indeed, in the Dodd-Frank Act, Congress specifically directed
the Commission, ``[i]n order to promote effective and consistent
global regulation of swaps,'' to ``consult and coordinate with
foreign regulatory authorities on the establishment of consistent
international standards with respect to the regulation . . . of
swaps [and] swap entities. . . .'' \6\ And when the G-20 leaders met
in Pittsburgh in the midst of the financial crisis in 2009, they,
too, recognized that a workable solution for global derivatives
markets demands coordinated policies and cooperation.\7\
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\6\ See section 752(a) of the Dodd-Frank Wall Street Reform and
Consumer Protection Act, Public Law 111-203, Title VII, 124 Stat.
1376 (2010) (``Dodd-Frank Act'').
\7\ See Leaders' Statement from the 2009 G-20 Summit in
Pittsburgh, Pa. at 7 (September 24-25, 2009) (``We are committed to
take action at the national and international level to raise
standards together so that our national authorities implement global
standards consistently in a way that ensures a level playing field
and avoids fragmentation of markets, protectionism, and regulatory
arbitrage''), available at https://www.treasury.gov/resource-center/international/g7-g20/Documents/pittsburgh_summit_leaders_statement_250909.pdf.
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Our rule change regarding MSE is true to the direction of
Congress in the Dodd-Frank Act, and honors the commitment of the G-
20 leaders at the Pittsburgh summit. Differences between countries
in the detailed timing and calculation requirements with respect to
uncleared margin compel participants in these global markets to run
multiple compliance calculations--for no particular regulatory
reason. This not only forces market participants to bear unnecessary
costs, but actually hinders compliance with margin requirements
because of the entirely foreseeable prospect of calculation errors
in applying the different rules.
As noted above, now is the time to address this disconnect in
MSE timing and calculation requirements because the financial end-
users to which the MSE definition applies are coming into scope of
the margin rules. During the unfortunate events of the financial
crisis, we learned that coordination among global regulators,
working towards a common objective, is essential. That lesson
remains true today, and we are reminded that disregarding this
reality has the potential to weaken, rather than strengthen, the
effectiveness of our oversight and the resilience of global
derivatives markets.
The Benefits of Codifying Staff Relief and Re-Visiting Our Rules
The second rule change that we are adopting would codify
existing Staff no-action relief in recognition of market realities.
The Commission's Staff often has occasion to issue relief or take
other action in the form of no-action letters, interpretative
letters, or advisories on various issues and in various
circumstances. This affords the Commission a chance to observe how
the Staff action operates in real-time, and to evaluate lessons
learned. With the benefit of this time and experience, the
Commission should then consider whether codifying such Staff action
into rules is appropriate.\8\ As I have said before, ``[i]t is
simply good government to re-visit our rules and assess whether
certain rules need to be updated, evaluate whether rules are
achieving their objectives, and identify rules that are falling
short and should be withdrawn or improved.'' \9\
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\8\ See comments of Commissioner Dawn D. Stump during Open
Commission Meeting on January 30, 2020, at 183 (noting that after
several years of no-action relief regarding trading on swap
execution facilities (``SEFs''), ``we have the benefit of time and
experience and it is time to think about codifying some of that
relief. . . . [T]he SEFs, the market participants, and the
Commission have benefited from this time and we have an obligation
to provide more legal certainty through codifying these provisions
into rules.''), available at https://www.cftc.gov/sites/default/files/2020/08/1597339661/openmeeting_013020_Transcript.pdf.
\9\ Statement of Commissioner Dawn D. Stump for CFTC Open
Meeting on: (1) Final Rule on Position Limits and Position
Accountability for Security Futures Products; and (2) Proposed Rule
on Public Rulemaking Procedures (Part 13 Amendments) (September 16,
2019), available at https://www.cftc.gov/PressRoom/SpeechesTestimony/stumpstatement091619.
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This second rule change would codify the alternative IM
calculation method set out in Staff no-action Letter No. 19-29.\10\
It would provide that a swap dealer may use the risk-based model
calculation of IM of a counterparty that is a CFTC-registered swap
dealer as the amount of IM that the former must collect from the
latter. The release states the Commission's expectation that this
alternative method of IM collection will be used by swap dealers
with a discrete and limited swap business consisting primarily of
entering into uncleared customer-facing swaps with end-user
counterparties, and then hedging the risk of those swaps with
uncleared swaps entered into with a few other swap dealers.
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\10\ CFTC Letter No. 19-29, Request for No-Action Relief
Concerning Calculation of Initial Margin (December 19, 2019),
available at https://www.cftc.gov/LawRegulation/CFTCStaffLetters/letters.htm?title=&field_csl_letter_types_target_id%5B%5D=636&field_csl_divisions_target_id%5B%5D=596&field_csl_letter_year_value=2019&=Apply.
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Simply put, not all swap dealers are created equal. It is
therefore appropriate to tailor our uncleared margin regime
accordingly. Letter No. 19-29 recognized this reality and smoothed
the rough edges of our otherwise one-size-fits-all uncleared margin
rules, and it is appropriate to codify that result.
Yet, under the rule amendments being adopted, this alternative
method is subject to the condition that the uncleared swaps for
which a swap dealer uses the risk-based model calculation of IM of
its swap dealer counterparty are entered into for the purpose of
hedging the former's own risk from entering into customer-facing
swaps with non-swap dealer counterparties. This is a departure from
the GMAC Margin Subcommittee, which did not recommend such a
condition.
I am concerned by comments we received suggesting that this
condition may cause this rule change to prove unworkable in
practice.\11\ I am encouraged that the rulemaking release addresses
some of these comments by, among other things, confirming: (1) The
flexibility of swap dealers as part of their hedging strategy to
match a set of customer-facing swaps with one or more hedging swaps
undertaken with swap dealer counterparties; and (2) that customer-
facing swaps entered into through anticipatory hedging or that are
subsequently terminated would be deemed hedges for purposes of the
alternative method of IM calculation. Nevertheless, if over time,
market participants find that the hedging condition causes this rule
change to fail to fulfill its intended purpose, I urge them to alert
the Commission so that it can consider appropriate adjustments.
---------------------------------------------------------------------------
\11\ See, e.g., Letter from BP Energy Company at 5 (given the
uncertainty as to what constitutes hedging, swap dealers may be
reluctant to rely on the alternative method of IM calculation) and 6
(limiting relief to hedge transactions may diminish its utility);
Letter from Futures Industry Association at 8 (complexity and added
risk of hedging condition will make the alternative method of IM
calculation impractical as counterparties will shy away from
undertaking swaps with swap dealers that rely on the alternative
method of calculating IM; also, cost, operational and documentation
burdens associated with hedging condition could lead small swap
dealers to cease providing risk management services to end-user
counterparties, leaving end users with unhedged risks).
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There Remains Unfinished Business
While I am pleased with the steps the Commission is taking,
there remains unfinished business in the implementation of uncleared
margin requirements. As an initial matter, U.S. prudential
regulators with oversight authority over bank swap dealers have not
adopted the same rule changes. As a result, although commenters
expressed support for the Commission proceeding with these rule
changes even in the absence of parallel action by the U.S.
prudential regulators, the operational difficulties confronting
market participants that are coming into scope of the margin rules
will not be fully addressed when they enter into uncleared swaps
with bank swap dealers. I look forward to continuing the dialogue
with our regulatory colleagues at other U.S. agencies to support
addressing these challenges.
In addition, the report of the GMAC Margin Subcommittee
recommended several actions, beyond those that we are adopting, to
address the hurdles associated with the application of uncleared
margin requirements to end-users. Having been present for the
development of the Dodd-Frank Act, I recall that the concerns
expressed by many lawmakers at the time focused on the application
of the new requirements to end-users. The unique challenges with
respect to uncleared margin that caused uneasiness back in 2009-2010
are now much more immediate as the margin requirements are being
phased in to apply to these end-users. As the calendar turns into
the new year, I look forward to continuing to work together to
address the other recommendations included in the GMAC Margin
Subcommittee's report regarding applying the uncleared margin rules
to financial end-users. The need to do so will
[[Page 249]]
only become more urgent as time marches on.
Conclusion
To be clear, these amendments to the uncleared margin rules are
not a ``roll-back'' of the margin requirements that apply today to
the largest financial institutions in their swap transactions with
one another. Rather, they reflect a thoughtful refinement of our
rules to align them with the rest of the international regulatory
community, and to take account of specific circumstances in which
the rules impose substantial practical and operational challenges
(i.e., they are not workable) when applied to financial end-users
that are now coming within the scope of their mandates.
I am very appreciative of the many people whose efforts have
contributed to bringing this rulemaking to fruition. First, the
members of the GMAC, and especially the GMAC Margin Subcommittee,
who devoted a tremendous amount of time to provide us with a high-
quality report on complex margin issues during the turmoil at the
start of the pandemic. Second, Chairman Tarbert and my fellow
Commissioners for working with me on these important issues. And
finally, the Staff of the Market Participants Division, whose
tireless efforts have enabled us to advance these initiatives to
assure that our uncleared margin rules are workable for all and are
in line with international standards, thereby enhancing compliance
consistent with our oversight responsibilities under the Commodity
Exchange Act.
Appendix 4--Statement of Commissioner Dan M. Berkovitz
I. Introduction
I support today's two final rules that make tailored amendments
to the CFTC's Margin Rule.\1\ The Margin Rule requires swap dealers
(``SDs'') and major swap participants (``MSPs'') for which there is
no prudential regulator to post and collect, each business day,
initial and variation margin for uncleared swap transactions with
each counterparty that is an SD, MSP, or a financial end user with
material swaps exposure (``MSE'').\2\ The Margin Rule is a lynchpin
of the Dodd-Frank reforms for swaps markets, and critical to
mitigating risks in the financial system that might otherwise arise
from uncleared swaps.\3\ I support the final rules because they
provide targeted, operational improvements to the Margin Rule;
include backstops to deter any potential abuse; and are unlikely to
increase risk to the U.S. financial system.
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\1\ Margin Requirements for Uncleared Swaps for Swap Dealers and
Major Swap Participants, 81 FR 636 (Jan. 6, 2016) (``Margin Rule'').
\2\ Although addressed in the final rules, there are currently
no registered MSPs.
\3\ Section 4s(e) of the Commodity Exchange Act (``CEA''), as
amended by the Dodd-Frank Act, requires the Commission to adopt
rules for minimum initial and variation margin for uncleared swaps
entered into by SDs and MSPs for which there is no prudential
regulator.
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The two final rules address: (1) The definition of MSE and an
alternative method for calculating initial margin (``MSE and Initial
Margin Final Rule''); and (2) the application of the minimum
transfer amount (``MTA'') for initial and variation margin (``MTA
Final Rule''). The final rules align Commission requirements with
international frameworks developed by the Basel Committee on Banking
Supervision and the International Organization of Securities
Commissions (``BCBS/IOSCO''),\4\ and incorporate recommendations
made to the CFTC's Global Markets Advisory Committee.\5\ The final
rules also build off existing CFTC staff no-action letters that in
some cases have been in place since 2017, and that have operated
with no apparent detrimental effects.
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\4\ BCBS/IOSCO, Margin requirements for non-centrally cleared
derivatives (July 2019), available at https://www.bis.org/bcbs/publ/d475.pdf. The BCBS/IOSCO framework was originally promulgated in
2013 and later revised in 2015.
\5\ Recommendations to Improve Scoping and Implementation of
Initial Margin Requirements for Non-Cleared Swaps, Report to the
CFTC's Global Markets Advisory Committee by the Subcommittee on
Margin Requirements for Non-Cleared Swaps (Apr. 2020), available at
https://www.cftc.gov/media/3886/GMAC_051920MarginSubcommitteeReport/download.
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II. MSE and Initial Margin Final Rule
The MSE and Initial Margin Final Rule amends the definition of
MSE to align it with the BCBS/IOSCO framework, including the method
for calculating the average daily aggregate notional amount
(``AANA'') of swaps. The final rule provides for calculations based
on the average of the last business day in each month of a three-
month period. The Commission previously raised concerns that this
method of AANA calculation could potentially become less
representative of an entity's true AANA and swaps exposure,
potentially through the use of ``window dressing'' to artificially
reduce AANA during the measurement period.\6\
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\6\ See Margin Rule, 81 FR at 645.
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The MSE and Initial Margin Final Rule includes an important new
provision to address this issue. The final rule explicitly prohibits
any ``[a]ctivities not carried out in the regular course of business
and willfully designed to circumvent calculation at month-end to
evade meeting the definition of material swaps exposure . . . .''
\7\ The addition of this language to the final rule's regulatory
text will help ensure that CFTC efforts at international
harmonization will not come at the expense of the safety and
soundness of the U.S. financial system.\8\ I thank the Chairman and
the CFTC staff for working with my office to include this provision.
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\7\ MSE and Initial Margin Final Rule at new Sec. 23.151
(defining ``Material Swaps Exposure'').
\8\ The preamble to the MSE and Initial Margin Final Rule also
notes an analysis by the CFTC's Office of the Chief Economist
indicating that the new month-end AANA calculation method captures
substantially the same entities and total number of entities as the
Commission's previous daily AANA calculation method. As with any
rulemaking, the Commission is free in the future to periodically
review its data and confirm that the new AANA calculation method is
performing as expected.
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The MSE and Initial Margin Final Rule will also allow SDs and
MSPs for which there is no prudential regulator (``Covered Swap
Entities'' or ``CSEs'') to rely on the initial margin calculations
of the more sophisticated counterparties with whom they transact
swaps to manage their risks. This flexibility is limited to
circumstances where a CSE enters into uncleared swaps with an SD,
MSP, or swap entity to hedge its customer-facing swaps. This
amendment to the Commission's existing rules could help promote
liquidity and competition in swaps markets by increasing choice for
end-users that are CSE customers.
The MSE and Initial Margin Final Rule provides helpful direction
regarding the scope of hedging swaps for purposes of relying on a
CSE counterparty's initial margin calculations. As set forth in the
preamble to the final rule, a hedging swap must be consistent
(although not identical) with the statutory definition of ``bona
fide hedging transaction or position'' in CEA section
4a(c)(2)(B).\9\ The final rule also makes clear that existing
Commission regulations require a CSE that relies on its
counterparty's initial margin calculations to also take steps to
``monitor, identify, and address potential shortfalls in the amounts
of [initial margin] generated by the counterparty on whose [initial
margin] model the CSE is relying.'' \10\
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\9\ 7 U.S.C. 6a(c)(2).
\10\ MSE and Initial Margin Final Rule at section II(B).
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III. MTA Final Rule
To reduce operational burdens associated with de minimis margin
transfers, the Margin Rule provides that a CSE is not required to
collect or post margin until the combined amount of initial margin
and variation margin that is required to be collected or posted and
that has not been collected or posted with respect to the
counterparty exceeds $500,000--the MTA.\11\ This MTA level, in part,
helps limit the amount of a counterparty's uncollateralized,
uncleared swaps exposure and mitigate any systemic risk arising from
such swaps.
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\11\ 17 CFR 23.151.
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The MTA Final Rule addresses the application of the $500,000 MTA
level to a counterparty's ``separately managed accounts,'' as well
as the use of separate MTAs for initial and variation margin.\12\
The MTA Final Rule codifies separate treatment for separately
managed accounts and permits an MTA of $50,000 for each such account
of a counterparty. This approach responds to practical limits on the
ability of asset managers, for example, to aggregate initial and
variation margin obligations across multiple separately managed
accounts owned by the same counterparty. The MTA Final Rule also
provides that if certain entities agree to separate MTAs for initial
margin and variation margin, the respective amounts of MTA must be
reflected in their required margin documentation.
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\12\ Both aspects of the MTA Final Rule were the subject of CFTC
staff no-action letters issued in 2017 and 2019, respectively.
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These new provisions balance concerns over operational
inefficiencies and practical challenges in the Commission's MTA
rules against concerns that they may result in the exchange of less
total margin than would be the case under the Commission's current
[[Page 250]]
requirements. Comments in response to the proposed rule noted the
difficulties that would be associated with creating numerous
separately managed accounts solely to evade the comparatively low
$50,000 MTA for separately managed accounts. The MTA Final Rule also
defines separately managed account so that the swaps of such account
are not subject to a netting of initial or variation margin
obligations. This potentially provides further disincentive to
create separately managed accounts solely for the purpose of evading
the $50,000 MTA level for such accounts.
IV. Conclusion
Mitigating systemic risk to the U.S. financial system was a
primary objective of the Dodd-Frank Act in 2010, and of subsequent
Commission rulemakings to implement Dodd-Frank, including the Margin
Rule adopted in 2016. The Commission must remain committed to the
Margin Rule and vigilant for any large pool of uncollateralized,
uncleared swaps exposure. Today's targeted final rules, which codify
existing practices, include embedded backstops, and provide tailored
operational enhancements to the Margin Rule, are unlikely to present
systemic risks.
I thank staff of the Market Participants Division for their work
on these final rules.
[FR Doc. 2020-27736 Filed 1-4-21; 8:45 am]
BILLING CODE 6351-01-P