End-User Clearing Exemption Marginalized By Swap Dealer Margin Rules

Although non-financial End-Users may not be forced to clear their Swaps, they may find themselves facing the same costs for entering into un-cleared trades should the proposed margin requirements issued by the Prudential Regulators and CFTC become final.  Under the proposed rule all counterparties to an un-cleared swap would have to enter into a Credit Support Annex, or CSA, which would govern who, how and when collateral or margin would be posted against a swap position.  We would estimate that less than 5% of non-financial corporations have actually entered into CSA’s.  So for starters, lawyers stand to make some nice fees on negotiating CSA’s for all counterparties.

The rules do allow some flexibility on how Swap Dealers can set the threshold of the CSA and types of securities that corporates can post as collateral.  However, even if the threshold may initially be ample enough to handle price moves, you cannot simply put the CSA in the drawer and hope that you never have to post margin.  Counterparties will have to set up processes and systems to properly monitor and manage the CSA agreements.

Even if you have a CSA in place, they will have to be re-negotiated, as the current draft rule is different than common practice as Initial Margin would be collected by the Swap Dealer, i.e. on a one-way basis, and held in a segregated third-party account.  Variation margin throughout the life of the Swap will be bilateral between the two counterparties, so you can be paying or collecting collateral, depending on the mark-to-market of your portfolio.

Another challenge is that pre-enactment Swaps can be excluded from the margining requirement, so operationally this may sound better to have fewer Swaps affected, but from a credit standpoint, you cannot separate them in the event of bankruptcy.  So since it is not a regulatory requirement, if your Swap position is a positive mark-to-market with the Swap Dealer with the pre-enactment Swaps, but negative without, then you may not be in much of a negotiating position to ask for margin for the pre-enactment Swaps.  Should that Swap Dealer default, you could be out the value of your pre-enactment Swaps which were valued at a gain, vs. the one-way Initial Margin you posted for the post-enactment Swaps, although at least the collateral would be segregated.

The comment period has been extended to July 11, 2011, so this is one where you definitely have to pick up the pen or make the pilgrimage to DC as this rule will have a direct cost impact to you, whether it’s through legal fees or the cost to fund the posting of collateral. 

Go to this link to submit your comment today: http://comments.cftc.gov/PublicComments/CommentList.aspx?id=1019