On October 22, 2015, five federal agencies adopted a joint final rule establishing minimum initial and variation margin requirements for non-cleared swaps entered into by a registered swap dealer, major swap participant, security-based swap dealer or major security-based swap participant. The U.S. prudential regulators – the FDIC Board of Directors, the Office of the Comptroller of the Currency, the Federal Reserve Board, the Farm Credit Administration and the Federal Housing Finance Agency – adopted this final rule (PR final rule)  shortly before the U.S. Commodity Futures and Trading Commission (CFTC) adopted a substantially similar final rule on December 16, 2016, for margin requirements for non-cleared swaps entered into by a registered swap dealer or major swap participant that is not regulated by a U.S. prudential regulator (including non-bank subsidiaries of a bank holding company) (CFTC final rule and, collectively with the PR final rule, the final rules). However, the CFTC final rule materially deviates from the PR final rule in several ways, as noted below.
Importantly, the U.S. prudential regulators and the CFTC each specified (in interim final rules) that the margin requirements do not apply to certain non-cleared swaps and non-cleared security-based swaps of financial institutions with total assets of ten billion dollars or less or commercial end-users that would otherwise be exempt from clearing. The SEC has yet to issue final rules establishing margin requirements for security-based swap dealers and major security-based swap participants that are not regulated by a U.S. prudential regulator.
Hedge funds and other investment funds trading non-cleared swaps with registered swap dealers supervised by either the U.S. prudential regulators or the CFTC (covered swap dealers) will be indirectly impacted by the final rules and will likely face increased costs of trading non-cleared swaps as described below.
In a two-part guest series, Fabien Carruzzo and Philip Powers – partner and associate, respectively, at Kramer Levin – discuss the final rules and analyze their impact on hedge funds.
This first article addresses the calculation of a fund’s material swaps exposure, as well as the requirements under the final rules for covered swap dealers to collect and post initial and variation margin with respect to non-cleared swaps with their counterparties. The second article will address minimum transfer amounts; eligible collateral and haircuts; netting of exposure; documentation and industry initiatives; compliance obligations under the final rules; and the practical implications of the final rules on hedge funds. For additional insight from Carruzzo, see “OTC Derivatives Clearing: How Does It Work and What Will Change?” (Jul. 14, 2011). For more from Kramer Levin practitioners, see “‘Interval Alts’ Combine Benefits of Alternative Mutual Funds and Traditional Hedge Funds” (Jul. 16, 2015).
Material Swaps Exposure
A fund has material swaps exposure if it (and its affiliates) have an average daily aggregate notional amount of non-cleared swaps, foreign exchange forwards and foreign exchange swaps for June, July and August of the previous calendar year (calculated only for business days and counting affiliate trades only once) exceeding eight billion dollars.
The material swaps exposure determination applies to a fund for an entire calendar year. Accordingly, material swaps exposure would be calculated each year on January 1 based on June, July, and August of the previous year.
In determining whether a fund has material swaps exposure, the U.S. prudential regulators and CFTC note that it is reasonable for a covered swap dealer to rely in good faith on reasonable representations made by a fund as to whether that fund has material swaps exposure.
Change in Material Swaps Exposure Status
Once the final rules are effective for a fund, if a fund exceeds the material swaps exposure threshold based on June, Julyand August of the previous calendar year, then the stricter margin requirements applicable to a fund with material swaps exposure will apply only for trades entered into after the change in status is effective on January 1 of the following year.
Conversely, if a fund no longer has material swaps exposure based on June, July and August of the previous calendar year, then the less strict margin requirements will apply for all trades, including any outstanding trades at the time the change in status is effective (and any initial margin that had been previously collected would no longer be required under the final rules).
FX Forwards and Swaps
While the average daily notional amount of a fund’s foreign exchange forwards and swaps are taken into account for determining whether that fund has material swaps exposure, there is no requirement for a covered swap dealer to collect or post margin with respect to foreign exchange forwards and swaps.
Affiliate determinations in the final rules are largely based on the consolidation of financial statements as opposed to a “control” standard, which was previously proposed by the U.S. prudential regulators and the CFTC. The U.S. prudential regulators (but not the CFTC) also afforded themselves discretion to determine that entities will be deemed to be affiliates for purposes of the PR final rule where either entity provides significant support to, or is materially subject to the risk of losses of, the other entity.
By using the consolidation standard under the final rules, it is largely expected that investing across funds or fund complexes will not create affiliate relationships for purposes of the final rules. Additionally, a fund should not be consolidated with its investment manager other than in certain instances where the manager holds a large portion of the fund, including during a seeding period.
Initial Margin Posting
Initial Margin for Funds With Material Swaps Exposure
With respect to initial margin and a fund with material swapsexposure, a covered swap dealer must both collect and post margin on a daily basis with respect to any non-cleared swap. The amount of margin that is required to be collected and posted must be an amount at least equal to the amount required by either (1) an internal margin model meeting the requirements of the final rules and approved by the relevant U.S. prudential regulator, in the case of the PR final rule, or the CFTC or a registered futures association (e.g., the National Futures Association), in the case of the CFTC final rule; or (2) a standardized formula set forth in the final rules. In any case, a swap dealer may require a fund to post margin in excess of the minimum amount required by the final rules.
The standardized formula is based on the notional amount of the transactions in a non-cleared swap portfolio together with a table setting forth the respective initial margin percentages for types of swaps within that portfolio. The standardized formula recognizes risk offsets by including in the calculation the ratio of the net current replacement cost of the noncleared swaps in the portfolio to the gross current replacement cost of the non-cleared swaps in the portfolio, if documented under an “eligible master netting agreement” for such swaps.
Segregation of Initial Margin for Funds With Material Swaps Exposure
As between a covered swap dealer and a fund with material swaps exposure, all initial margin that is required to be posted by that swap dealer or fund must be segregated with one or more third-party independent custodians. Any excess initial margin that is posted by a fund with material swaps exposure, however, is not subject to the segregation requirements.
Any required segregation must be made pursuant to a custodial agreement that, among other things, prohibits (1) substituting or reinvesting funds or other property in assets that would not be eligible collateral under the final rules; and (2) lending activities of the custodian, including “rehypothecating, repledging, reusing or otherwise transferring” funds or other property held by the custodian. There is an exception that cash collateral may be held in a general deposit account with the custodian if the funds in the account are used to purchase eligible non-cash collateral within a reasonable time after the cash collateral is posted and that non-cash collateral is then segregated.
Initial Margin for Funds Without Material Swaps Exposure
With respect to initial margin and any fund without material swaps exposure, under the PR final rule a covered swap dealer must collect (with no requirement to post) initial margin at times and in the forms or amounts (if any) that the covered swap dealer determines appropriately address the credit risk posed by that fund and the risks of the relevant non-cleared swaps. No related requirement exists in the CFTC final rule.
A dealer is not required to segregate any initial margin that it collects from any such fund under the PR final rule, but any amount voluntarily posted by a swap dealer would be required to be segregated as described above.
Initial Margin Transfer Timing and Threshold for All Funds
Initial margin must be posted on or before the first business day following the “day of execution.” Where the parties enter into a swap (1) after 4:00 p.m. in the location of a party, the day of execution will be the next business day for both parties; or (2) on a different calendar day in the location of each party, the day of execution will be the later of the calendar days or, if that calendar day is not a business day for a party, the next business day for both parties.
A threshold of up to a $50 million ($20 million where the parties are affiliates under the PR final rule) may be applied to the aggregate credit exposures resulting from all non-cleared swaps between a fund and a covered swap dealer (and their respective affiliates). In that respect, the final rules explicitly note that separate accounts having multiple managers will not receive a separate threshold for each manager of a sleeve of that account despite operational issues that are likely to result.
Variation Margin Posting
With respect to variation margin, regardless of whether a fund has material swaps exposure, a covered swap dealer must both collect and post mark-to-market margin on each business day, for a period beginning on or before the business day following the day of execution and ending on the date of termination/ expiry. There is no segregation requirement with respect to variation margin, and no threshold is permitted.
Notably, the CFTC final rule differs from the PR final rule in that respect. The CFTC requires swap dealers (1) to rely on recentlyexecuted transactions, independent third-party valuations orother objective criteria; and (2) to specify in documentation the variation margin methodology with sufficient detail to allow its counterparty or any applicable regulator to independently calculate a reasonable approximation of the margin requirement.
In the case of the PR final rule or the CFTC final rule, for any fund without material swaps exposure, the final rules should not significantly change current practice with respect to its margin posting obligations.
 Margin and Capital Requirements for Covered Swap Entities, 80 Fed. Reg. 74,839 (Nov. 30, 2015); 12 CFR parts 45, 237, 349, 624 and 1221.
 Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 81 Fed. Reg. 635 (Jan. 6, 2016); 17 CFR parts 23 and 140.
 Supra notes 1 and 2.