WASHINGTON — Federal banking regulators gave ground in a final rule to raise collateral requirements for uncleared swaps, providing special consideration for swaps traded between affiliates of the same firm.
The rule, which was finalized Thursday by the Federal Deposit Insurance Corp. and Office of the Comptroller of the Currency, would require banks to post roughly $315 billion in additional capital.
But that was far less than originally envisioned in the plan released by regulators last year. In some cases, the margin savings under the final rule could be half of what it would have been under the 2014 proposal.
The compromise raised concerns with some regulators, but didn’t go far enough to please some in the industry.
FDIC Vice Chairman Thomas Hoenig said that he would have preferred that the rule require more collateral on inter-affiliate transactions. But he said he supported the final rule because he felt that it would protect taxpayers from the risk posed by uncleared swaps in insured institutions. He also noted that the Commodity Futures Trading Commission and Securities and Exchange Commission could require nonbank affiliates to post margin as part of their versions of the rule.
“While the system overall would have been best served if banks posted as well as collected margin with their affiliates, much is accomplished with the requirement that the insured bank collect margin,” Hoenig said. “I also recognize that other agencies with jurisdiction over nonbank affiliates could require these firms to collect margin as they finalize their rules on this matter.”
But Greg Baer, president of The Clearing House Association – a trade group representing many of the largest banks affected by the rule – criticized the final rule’s inter-affiliate swap requirement as unnecessary and costly, though he acknowledged that the final rule is an improvement over the “two-way” initial margin requirement envisioned in last year’s proposal.
“These are internal trades that do not increase risk to the organization, but simply allow for existing risk to be consolidated and managed in one entity,” Baer said. “While one-way posting of margin between affiliates is clearly better than two-way, this rule increases the cost of serving clients and hedging risk while doing nothing to enhance the safety and soundness of the organization.”
Overall, the rule requires registered U.S. swap dealers and major swap participants that are also federally insured depository institutions to post a specified amount of collateral – known as margin – to offset the costs of winding down an uncleared swap. Swap dealer and major swap participants are registered with the CFTC and SEC and generally are defined as entities that engage in more than $8 billion in swaps activity per year. The rule would apply to swaps initiated after the effective date and would not be applied retroactively.
Swap dealers covered by the rule would be required to post “initial margin” upon the execution of a swap, determined either using a standardized table or, more likely, an internal model approved by the entity’s supervising agency. In general, the initial margin requirements would be around 30% greater than the margin requirements for similar cleared swaps. The initial margin can be held as cash, foreign currency, treasuries or certain corporate and municipal bonds. The rule also requires so-called “variation margin” to be posted if the values of a transaction shift over time. That margin will have to be posted in cash.
In a break from the proposal, the final rule allows the covered swap entity to collect initial margin for its inter-affiliate swaps, but it would not have to post that margin – that is, send it to a designated third party. Instead the entity would have to calculate and document the initial margin that it would have been required to post if the inter-affiliate swaps were treated like any other swap. Affiliates would still have to exchange variation margin as required by non-affiliates.
The changes account for a substantial savings in collateral for many of the largest and most complex institutions compared to the 2014 proposal. Many of those large banks have affiliates that are broker-dealers, futures commission merchants or other entities that enter into a large volume of transactions with one another – in some cases rivaling the volume of transactions they enter into with third parties.
During a board meeting, FDIC Chairman Martin Gruenberg said the rule is an important milestone in moving toward a more stable global financial system.
“Establishing margin requirements for non-cleared swaps is one of the most important reforms of the Dodd-Frank Act,” Gruenberg said. “These margining practices will promote financial stability by reducing systemic leverage in the swaps marketplace, and promote the safety and soundness of banks by discouraging the excessive growth of risky non-cleared swaps positions.”
The rule was a joint rulemaking between the FDIC, Federal Reserve, Federal Housing Finance Agency, Farm Credit Administration and OCC, and will tie in with separate but related rules by the CFTC and SEC that have not yet been finalized. The OCC adopted the final rule earlier Thursday morning, while the FCA approved the rule earlier in the week. The FHFA and Fed are expected to finalize the rule soon. It is slated to go into effect on Sept. 1, 2016.
The International Swaps and Derivatives Association, a trade association representing derivative counterparties, welcomed the interagency rule as an important first step toward a consistent international regime for uncleared swaps. But the group warned that complying with the rule by the Sept. 1 deadline will be “challenging.”
“Many changes need to be made to systems, documentation and collateral practices,” said Mary Johannes, a senior director for ISDA. “To complete all that ahead of the September 2016 implementation date will be challenging, particularly as regulators in other jurisdictions have not yet published final rules and harmonization across jurisdictions is not yet clear. We will continue to work toward that harmonization and welcome this first step.”
FDIC estimates that the rule will result in affected banks and their counterparties posting an additional $315 billion in margin against their uncleared swap positions, assuming they relied on internal models rather than the standardized table. The largest U.S. banks -- including JP Morgan, Citi, Bank of America, Morgan Stanley and Goldman Sachs – would likely account for the majority of that collateral.
Swaps -- also known as over-the-counter derivatives – are a multi-trillion-dollar international market of contracts that allow counterparties to exchange a fixed price or benchmark for a fluctuating one, thus allowing companies to hedge their exposures to changing market process and values. The financial crisis exposed the potential of the previously unregulated swaps market to spread financial contagion from unhealthy companies to healthy ones, most famously in the case of American International Group, which required billions in federal bailouts in 2008 and 2009 because of its exposure to credit default swaps.
The CFTC and SEC established rules requiring certain swaps to be cleared, or routed through a central clearinghouse in order to mitigate the potential for one company’s failure to affect the rest of the economy. But certain swap transactions are so unique that they would not have a market outside of the two counterparties and therefore cannot be cleared. Dodd-Frank requires those uncleared swaps to post additional margin in order to reflect the additional risk they pose to the financial system.
The uncleared swap margin rule was initially proposed in 2011 but was revised in 2014 to reflect agreements in the international Basel III accord regarding uncleared swaps margin requirements. FDIC also passed an interim final rule as required by 2015’s Terrorism Risk Insurance Program Reauthorization Act that exempts commercial “end-users” that are engaged in swaps as bona fide hedge and depository institutions with less than $10 billion in assets, thus curbing the impact on community banks.