The CFTC issued new final rules addressing the manner in which swap dealers hold collateral posted by their counterparties.
The new rules will become effective (i) as to new counterparties, 180 days after the final rules are published in the Federal Register and (ii) as to existing counterparties, 360 days after such date.
The rules require that a swap dealer (i) notify its counterparty before entry into any uncleared swap that the counterparty has the “right” to require that any initial margin posted by the counterparty be segregated, (ii) that the swap dealer identify at least one “creditworthy non-affiliate” and potentially other “independent” legal entities that may act as custodian and (iii) provide information regarding the price of segregation for each identified custodian to the extent that such information is available. The required information must be made available at least once a calendar year and the notice must be provided to a specified person at the counterparty, who may be “the officer of the counterparty responsible for the management of collateral” or, if there is no such identified officer, a named hierarchy of individuals leading up to the “highest-level decision maker for the counterparty.” The rules require a confirmation of the receipt of the notice and the segregation decision.
Some additional notable aspects of the rules include:
- A swap dealer would not be able to enter into a swap with a counterparty that had elected segregation until the terms of the custodial arrangements had been agreed.
- A counterparty would be able to change its segregation election at any time, but only do so on a prospective basis. (In other words, a counterparty can not price a swap on the basis that its collateral does not require segregation and then demand segregation on the basis of the same pricing.)
- An agreement for the segregation of margin is required to be in a writing, as to which the “custodian is a party.” As a general matter (that is, in a non-default situation), withdrawals from the segregated account by the swap dealer may be made only with the agreement of both parties and notice of any such withdrawal must be given to the other party. In a default situation, the non-defaulting party acting on its own may provide a representation to the custodian that it is permitted to withdraw the collateral, although the defaulting party must be “immediately notified” of such action. The representation by the non-defaulting party must be made “under other or penalty of perjury.”
- Margin that is required to be segregated may only be invested as provided under CFTC Rule 1.25. The swap dealer and the counterparty may agree as to how profits and losses resulting from such segregation are to be allocated.
- The CCO of each swap dealer shall report (on a quarterly basis) to any counterparty that elects not to segregate collateral whether the “back office procedures” of the swap dealer were (at any point during the previous quarter) “not in compliance with the agreement of the counterparties.”
- The final rules also include certain amendments relating to the bankruptcy treatment of portfolio margining accounts.
The CFTC has taken a provision of Dodd-Frank that does not make a lof of sense to start and imposed burdensome and expensive conditions that are not easily understandable for market participants.
Section 4s(l) of the CEA, which was added by Dodd-Frank, gives a swap counterparty a “right” to have its collateral segregated. As the CFTC points out in the the adopting release, a counterparty has always had the “right” to have its collateral segregated: this provision is essentially a notice requirement that a counterparty can negotiate for collateral segregation, provided that it is willing to pay the costs of such segregation.
Where the CFTC goes wrong, as a starting matter, is its imposition of needlessly specific requirements as to whom the notice must be provided: i.e., the “officer” in charge of collateral, and potentially the highest ranking person in the company. A more sensible approach would simply be to include the acknowledgement of notice in the swap documents themselves, rather than imposing an additional procedure that is extremely specific and does not match actual practice.
The greater problem with the rule is the requirement that any segregated collateral may only be re-invested in accordance with CFTC Regulation 1.25. In other words, a counterparty can elect to have its collateral segregated, but once it so elects, it loses the right to have the collateral invested as it chooses. Why shouldn’t a counterparty be able to elect both segregation and freedom to invest as the counterparty chooses, particularly as the counterparty generally takes all the profit and loss from the investment?
