Margin Requirements

I. For Covered Swap Entities

Note: the following guidelines apply only to swap dealers and major swap participants which are already “covered”, i.e. already regulated by one of the following: OCC, FDIC, Federal Reserve, FCA, FHFA. “Uncovered” swaps dealers and major swap participants should see section II below.

In this case, “swap entities” are defined as “swap dealers and major swap participants” as well as “security-based swap dealers and major security-based swap participants.” (details)

Initial Margins

A swap entity may use one of two methods to calculate the initial margin requirements.

Standardized table.
Approved internal margins model. better reflects the specific needs of its particular transaction. Such a model would need to be periodically benchmarked against comparable derivatives requirements.

However, in cases involving nonfinancial end users or low-risk financial users, the swap entity could choose not to require initial margins, provided that the exposures were below the swap entity’s credit exposure limits. Since such a rule allows uncollateralized risk, swap entities must be sure to accurately assess the credit risk posed by its counterparty. Again, no swap entity or high-risk entity may go uncollateralized, unless that counterparty’s cumulative amount is under the minimum transfer amount ($100,000).

Variation Margins

Once the swap entity and counter party have entered into a deal, the swap entity must collect variation margins based on the mark-to-market change in value from the date entered into minus the value of all variation previously collected. Like the initial margins, for some low-risk or non-financial users, or if it is under the minimum transfer level, no variation margin is required. Swap entities must calculate and collect variation margins from fellow swap entities or high-risk financial users every day, but only calculate and collect from low-risk and nonfinancial users once a week. Should a counterparty refuse to pay the variation margin, and the swap entity makes an effort to collect the margin, then the swap entity is not in violation of the proposed rule.

Margin Types

Swap entities must adequately document the methods used for calculating the value of each swap, and the collateral collected for either type of margin must be one of the following:

(i) immediately available cash funds;

(ii) an obligation of or one guaranteed by the US government;

(iii)a debt obligation of the Federal National Mortgage Association, the Federal Home Loan Mortgage Corporation, the Federal Home Loan Banks, and Farmer Mac (initial margin only);

(iv) an “insured obligation” (initial margin only).

The value of the non-cash collateral must be closely monitored, and any change in value accounted for in initial or variable margins. No types of non-cash collateral other than those listed above may be used. This collateral must be segregated and placed with an independent third party, which is prohibited from transferring those funds.

These margin requirements apply to all covered US swap entities, regardless of the nationality of the counterparty. However, if the swap entity and counterparty are both organized outside US law and no US-based entity has insured the transaction, the proposed rule does not apply.

II. For Uncleared Swaps

Note: the following applies only to uncleared swaps traded by “uncovered” swap dealers and major swap participants. For covered swap entities, see above.

How to Calculate Initial Margin

Covered swap entities must calculate initial margins for themselves and all counterparties that are swap dealers, major swap participants or financial entities using one of two systems:

A risk-based model that is either currently used by DCOs, entities subject to a prudential regulator, or sold by market vendors for margining cleared swaps. (details)
Such models must have sound theoretical basis and empirical support, measure all material risks, use at least one year of historic price data, set margin to cover 99% of price changes over a 10-day liquidation time horizon. The methodology must be reported clearly enough to allow independent calculations. Swap entities must monitor margin coverage once a day, and conduct back tests and stress tests once a month. Swap entities must file each model with the CFTC, and include an explanation of how it complies with regulations, its mechanics, its theoretical basis, its empirical support, and any third party validation. The Commission may approve, deny, amend or request modifications to any model.
An alternative method which takes uses a swap in the same asset class cleared by a DCO with comparable terms and conditions (or, if there is no such swap, using futures contracts). (details)
The swap entity calculates the number of units in the cleared swap necessary to equal the uncleared swap, determine the amount of margin the DCO would require for those units, and then multiply that amount by 2.0 (or 4.4 if using a futures contract). Risk reductions may not be applied across asset classes except currency and interest rates. Reductions must be shown to have sound theoretical basis and empirical support. No reduction may exceed 50% of the required margin amount. Swap entities must monitor their coverage and collect additional margin if appropriate. The CTFC may require additional margin at any time.

How to Calculate Variation Margin

Variation margin is calculated based to credit support arrangements drawn up between swap entities and their counterparties. Methodology must be recorded with enough detail to allow independent calculations, including an explanation of how it complies with CFTC regulations, the mechanics, the theoretical basis, and any empirical support. At any time the CFTC may require a modification in methodology.

Credit Support Arrangements and Margin Treatments

All swap entities must negotiate credit support arrangement documentation with each counterparty they trade with. The credit support arrangement must specify the methodology used to calculate initial and variable margin (and any reference contracts used for alternative methods) as well as any thresholds beneath which margin need not be paid.

Margin rules vary among the different possible counterparty combination:

Between swap entities and swap dealers or major swap participants. Before the execution of the uncleared swap, the counterparty shall post initial margin and maintain that margin until the swap is liquidate according to the terms specified in the credit support arrangement. The day after the swap is executed, the counterparty must begin to pay variation margin, and continue to make payments until the swap is liquidated.
Between swap entities and financial entities. Same as above, except in regard to thresholds and variation margins. Swap entities may apply a threshold below which a need not hold margin, as long as the counterparty is subject to a prudential regulator, does not have significant unclear swaps exposure, and only uses swaps to hedge risk. The threshold must be the lesser of $15-45 million or 0.1-0.3% of the swap entities regulatory capital. Swap entities must calculate a hypothetical variation margin requirement as if the counterparty were a swap dealers instead of a financial entity and compare the amount for risk management purposes.
Between swap entities and non-financial entities. Same as above, except the calculation of the margin threshold must be specified in the credit support arrangement, and must make the same calculations of hypothetical variation margins as dealers trading with financial entities.

These margin rules apply unless the amount is less than the minimum transfer amount. If more than one uncleared swap is executed between counterparties, margin may be calculated on an aggregate basis. If a counterparty refuses to pay variation margin, the swap entity is not in violation of regulation if it has made an effort to collect the margin or is in process to terminate the deal.

Types of Margin

Covered swap entities shall post and accept only the types of initial margin specified in the credit support arrangement. If the counterparty is a swap dealer, major swap participant, or financial entity, the following assets may be used: cash funds, obligations of the United States, one of several types of federal mortgage obligations. If the counterparty is a non-financial entity, only assets which can be valued on a periodic basis may be used. No assets may be posted which are already an obligation of the counterparty.

For variation margin, only assets specified in the credit support arrangement may be used. For agreements where counterparties are swap entities, major swap dealers, or financial entities, those assets must be either cash or US Treasury securities. For non-financial entities, assets used but be easily valued at regular intervals.

Haircuts must be applied to margins specified in the credit support arrangements which reflect the credit and liquidity of the asset. Haircut minimums are listed in the table attached to the rule. At any time, the CFTC may require further information on margins, or to have a asset replaced by a less risky asset, or to modify a haircut.

The credit support arrangement should specify where margin assets will be held. The counterparty must have the opportunity to select an independent custodian. The custodian must be location in a jurisdiction with the same insolvency regime as the swap entity and may at no time rehypothecate the assets or invest in any risky assets.

To read the text of the proposed rule in full, click here.