SPEECHES & TESTIMONY

Statement of Chairman Timothy Massad, Final Rule on Margin for Uncleared Swaps

December 16, 2015

The rule this Commission is adopting today is one of the most important elements of swaps market regulation set forth in the Dodd-Frank Act. Although we have mandated clearing for standardized swaps, there will always be a large part of the market that is not cleared. This is entirely appropriate, as many swaps are not suitable for central clearing because of limited liquidity or other characteristics. Our clearinghouses will be stronger if we exercise care in what is required to be cleared. However, we must take steps to protect against such activity posing excessive risk to the system. That is why margin requirements for uncleared swaps are important.

The rule we are adopting today is strong and sensible. It requires swap dealers and major swap participants “covered swap entities” or “CSEs”) to post and collect margin with financial entities with whom they have significant exposures. It requires initial margin, which is designed to protect against potential future loss on a default, as well as variation margin, which serves as mark-to-market protection. It allows for the use of a broad range of types of collateral, but only with appropriate haircuts. It requires a greater level of margin than for cleared swaps, given that uncleared swaps are likely to be less liquid. It requires segregation of margin with third party custodians, and prohibits rehypothecation.

While there are costs to this rule, they are justified in light of the potential risks that uncleared swaps can pose. We learned this firsthand in the global financial crisis, which resulted in dramatic suffering and loss for American families.

The swap activities of commercial end-users were not a source of significant risk in the financial crisis, and we must make sure that they can continue using the derivatives markets effectively and efficiently. Accordingly, an important feature of our rule is that these margin requirements do not apply to swaps with commercial end-users. This was an element of our proposed rule and is in accordance with the intent of Congress. Instead, our rule focuses on those entities that create the greatest risks to our system through uncleared swaps: the large financial institutions with the greatest amount of swap activity.

Our rule is practically identical to the rules of the United States banking regulators, and substantially similar to international rules. Harmonization is critical to creating a sound international framework for regulation. Shortly after I took office, I committed to doing all we could to achieve such harmonization, and we have succeeded. For example, a year ago there were significant differences between proposals by the CFTC as well as the prudential regulators on the one hand, and international regulators on the other. But today, all these rules are substantially similar. This is true with respect to a number of provisions, including a two-way “post and collect” obligation; the material swaps threshold that determines when the requirements apply; the minimum transfer amount; the types of permissible collateral; the haircuts used in valuing types of collateral; the general provisions on models for calculating margin; segregation requirements; and the use of different currencies for collateral. We have also taken into account concerns related to the timing of when margin must be posted and made changes to address the complexities of cross-border transactions.

Today’s rule is designed to address the potential risks that can arise if a CSE or large financial entity defaults on transactions with another CSE or large financial entity. We are particularly seeking to reduce the risk that such a default leads to further defaults by those counterparties, given the interconnectedness of our financial system. We became all too familiar with that risk in 2008. Margin is designed to reduce the risk of cascading defaults by enabling the non-defaulting party to recover its loss. Some will characterize this as expensive insurance, as both parties must post initial margin as protection against potential future loss, even though in default, only one would actually recover against the margin. But we need only remember the costs of the crisis to our economy to recognize that this is, on the contrary, quite sensible.

The issue of how our rule should apply to inter-affiliate transactions has received a lot of attention. I believe we should look at this issue in terms of the goals of the rule, which are first and foremost to avoid the potential for the buildup of excessive risk from bilateral transactions between unaffiliated parties. Inter-affiliate transactions are not outward-facing and thus do not increase the overall risk exposure of the consolidated enterprise to third parties. Instead, they are typically a means for the consolidated enterprise to centrally manage risk related to the activities of multiple subsidiaries. Imposing the same third-party transaction standards on these internal activities of consolidated entities is likely to significantly increase costs to end-users without any commensurate benefit. Nevertheless, we have imposed some protections and requirements.

First, we must make sure that inter-affiliate transactions are not used as a loophole or as a means to escape the obligation to collect margin from third parties. This could occur, for example, if an affiliate in a jurisdiction that does not have comparable margin requirements enters into a swap with a third party without collecting margin, and then enters into an affiliate swap to transfer that risk. Our rule imposes a strong anti-evasion standard. A CSE is required to collect margin from an affiliate if that affiliate is, directly or indirectly, engaging in an outward facing swap in a situation where it should be, but is not, collecting margin. In addition, our proposal on the cross-border application of our margin rule, which is the subject of a separate rulemaking, also addresses this. The proposal provides that any affiliate that is consolidated with a U.S. parent is subject to requirements to collect margin from third parties no matter where the affiliate is located and whether or not it is guaranteed by the U.S. parent.

We have seen how global financial institutions have changed their business models to “deguarantee” the transactions of their overseas swap dealers so as to circumvent certain U.S. requirements. Whether guaranteed or not, swap risk created by an affiliate abroad could harm our financial system. That is why we have a strong anti-evasion standard in this rule and why we are addressing this through the cross-border aspects of the rule. I hope that we can finalize that part of the rule early next year.

In addition, our rule requires segregation of margin and prohibits rehypothecation, which prevents the affiliate that created the outward exposure from using the margin for something else, thus leaving itself more vulnerable to a default.

Second, we have required that variation margin be exchanged for all inter-affiliate swaps. This provides mark-to-market protection to either side, and prevents the potential buildup of a liability owed by one affiliate to another.

Third, we have required that inter-affiliate swaps be subject to a centralized risk management program that is reasonably designed to monitor and to manage the risks associated with such transactions. Some have suggested that, even if inter-affiliate swaps do not increase exposure to third parties, we should require initial margin for all inter-affiliate swaps to enhance that internal risk management. But that would be a very costly and not very effective way for us as a regulator to enhance such risk management. For example, it would not make sense to have a rule that required initial margin on, say, a $100 million inter-affiliate swap, when one affiliate could loan the other $100 million and not collect any margin. Similarly, a CSE could collect Treasury securities (or other non-cash collateral) from an affiliate as initial margin, but then loan the same amount of other securities back to the affiliate in a separate transaction which is not subject to requirements. The point is, if the concern is the adequacy of central risk management, then we should focus on that subject more generally. We should not attempt to address it by imposing on all inter-affiliate trades an initial margin requirement that is designed to address default risk on trading relationships between unaffiliated parties.

It is also important to remember that the definition of “affiliate” in our rule is limited to consolidated entities. This means that any swap with an affiliate that is not consolidated would be subject to the same margin requirements as third party swaps. This would be the case, for example, if a swap dealer enters into a swap with a mutual fund managed by an affiliate.

The fact that we are not generally requiring an exchange of initial margin in inter-affiliate transactions is also consistent with the rule this Commission adopted in 2013, which provided an exception to the clearing mandate for inter-affiliate transactions. In that rulemaking, the Commission considered, but decided against, requiring the exchange of initial margin or variation margin as a condition for electing the exemption. It did so out of a concern that such requirements “would limit the ability of U.S. companies to efficiently allocate risk among affiliates and manage risk centrally.” A requirement to exchange initial margin on all uncleared inter-affiliate transactions would effectively contravene the inter-affiliate clearing exemption, as it would likely be cheaper to clear the inter-affiliate swap. However, I think the case for variation margin is different, and that is why I support imposing a general requirement for exchange of variation margin for inter-affiliate swaps. While this goes further than what the Commission did in 2013, I believe it is a necessary and reasonable addition to the overall protections of the rule.

In addition to the goal of minimizing systemic risk, I also considered our desire to harmonize with the prudential regulators and international standards as much as possible, so that we do not create inconsistencies in the regulatory framework or incentives for regulatory arbitrage. The prudential regulators’ rules require the exchange of variation margin in inter-affiliate transactions, as ours do. They did not require the two-way exchange of initial margin; instead they required a “collect only” approach. This is similar to what federal law already requires, as Section 23 A and B of the Federal Reserve Act imposes requirements on inter-affiliate transactions by insured depositary institutions designed to protect the insured depository institutions. Those requirements do not apply to CSEs subject to our rule. In addition, if we were to adopt a collect only approach to initial margin, it would result in the two-way approach for transactions between the CFTC’s CSEs and the CSEs subject to the prudential regulators’ rules that the prudential regulators did not adopt. Instead, we have required the posting of initial margin to affiliated CSEs regulated by the prudential regulators to ensure consistency with the requirements of the prudential regulators’ rules. By doing so, we can help enforce the prudential regulators’ goal and the existing Section 23 framework.

With respect to international harmonization, we expect the rules to be adopted soon by Europe and Japan to not require initial or variation margin for inter-affiliate swaps. Similarly, the joint Basel Committee on Banking Supervision and the International Organization of Securities Commissions standards agreed upon in 2013 stated that the exchange of initial or variation margin for inter-affiliate swaps is “not customary” and expressed concern that imposing such requirements would result in “additional liquidity demands.” Our rule is somewhat more conservative than the international standards, but I believe the differences are not so great as to create significant international disparities.

In conclusion, the differences in our views on inter-affiliate margin do not reflect differences in the level of concern about the safety of the system or avoiding the problems of the past. They reflect differences in our analysis of what is accomplished by inter-affiliate initial margin. I believe the rule we are adopting today is a strong and sensible approach that will contribute to the strength and resiliency of our financial system.

Last Updated: December 16, 2015