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From Banking and Finance Law Daily, October 22, 2015

FDIC board approves margin and capital requirements for swap entities

By John M. Pachkowski, J.D.

Following a nearly five-year journey, the Federal Deposit Insurance Corporation’s Board of Directors has approved a final rule that will implement provisions of the Dodd-Frank Act that requires the FDIC, along with the Office of the Comptroller of the Currency, Federal Reserve Board, Farm Credit Administration, and Federal Housing Finance Agency, to establish margin and capital requirements for a “covered swap entity” that is supervised by one of the agencies. At its Oct. 22, 2015, meeting, Comptroller of the Currency Thomas J. Curry, an ex officio board member, stated that he had signed off on the final rule for the OCC.

The final rule is effective April 1, 2016.

Background. The agencies first proposed the margin and capital requirements in May 2011 and issued another notice of proposed rulemaking in September 2014 that superseded the 2011 proposal. The final rule is also consistent with the international framework on margin requirements published by the Basel Committee on Banking Supervision and the International Organization of Securities Commissions in September 2013. The final rule reflects provisions of the Terrorism Risk Insurance Program Reauthorization Act of 2015 (TRIPRA) that exempted swaps of certain commercial end users that are entered into for hedging purposes from the agencies’ margin rules for non-cleared swaps.

To address the TRIPRA amendments, the FDIC’s board also approved an interim final rule that provides that the agencies' margin requirements shall not apply to certain swaps entered into by commercial end users and by small financial institutions, pursuant to TRIPRA. The interim is effective April 1, 2016, and comments are required by Jan. 31, 2016.

Risk-based approach. The final rule will use a risk-based approach that distinguishes among four separate types of swap counterparties:

  • counterparties that are themselves swap entities;
  • counterparties that are financial end users with a “material swaps exposure”;
  • counterparties that are financial end users without a material swaps exposure; and
  • other counterparties, including sovereigns and multilateral development banks.

A “material swaps exposure” is defined under the final rule as an average daily aggregate notional amount of non-cleared swaps, non-cleared security-based swaps, foreign exchange forwards and foreign exchange swaps with all counterparties for June, July, and August of the previous calendar year that exceeds $8 billion, where such amount is calculated only for business days.

Capital requirements. The final rule would require a covered swap entity to comply with risk-based and leverage capital requirements already applicable to that covered swap entity as part of its prudential regulatory regime. In a memorandum to the FDIC’s board, the agency’s staff noted, “Compliance with these regulatory capital rules is sufficient to offset the greater risk, relative to the risk of centrally cleared swaps, to the swap entity and the financial system arising from the use of non-cleared swaps, and would help ensure the safety and soundness of the covered swap entity.”

Margin requirements. Under the final rule, a covered swap entity must exchange initial margin with counterparties that are swap entities, or financial end users with material swaps exposure. The covered swap entity’s minimum initial margin requirement can be calculated in one of two ways:

  • a Standardized Table set out in an appendix of the final rule; or
  • an Internal Model that satisfies the criteria outlined within the final rule and has been approved by the supervising agency.

If a covered swap entity uses an internal model, that model must be approved by its supervisory agency. The internal model must also certain standards relating to technical aspects of the model, as well as broader oversight and governance standards. The FDIC’s staff memorandum noted that the standards are similar to standards that are already required for internal regulatory capital models.

A covered swap entity will also be required to exchange variation margin on swaps with all counterparties that are swap entities; or financial end users. In light of the January 2015 TRIPRA amendments, the variation margin requirement will not apply to certain swaps that a covered swap entity enters into with commercial end users and with certain small financial institutions.

Collateral. The final rule also imposes a number of requirements regarding the types and uses of collateral that a covered swap entity may post or collect to meet its minimum margin requirements.

For initial margin, the final rule permits cash as well as certain assets expected to remain highly liquid during a period of financial stress. To meet its variation margin, a covered swap entity will only be permitted to exchange immediately available cash funds denominated in U.S. dollars or the currency of settlement swaps with another swap entity. For a covered swap entity’s swaps with a financial end user with material swap exposure, in addition to funds denominated in U.S. dollars or the currency of settlement, the parties would also need to exchange funds denominated in any major currency as well as non-cash collateral that is eligible to satisfy initial margin requirements.

The final rule also requires that a covered swap entity segregate any collateral, other than variation margin that it posts to its counterparty, one or more third-party custodians. These third-party custodians cannot be an affiliate of the covered swap entity or the counterparty. There are also limitations placed on the third-party custodians. For instance, they cannot rehypothecate, repledge, reuse, or otherwise transfer, any of the funds or other property it holds.

Compliance dates. Although the final rule is effective April 1, 2016, it includes a set of compliance dates by which covered swap entities will have to comply with the minimum margin requirements for non-cleared swaps and are consistent with the Basel Committee’s 2013 international framework.

Variation margin requirements would apply to large covered swap entities starting on Sept. 1, 2016, and to all remaining covered swap entities on March 1, 2017. Initial margin requirements would be phased in between Sept. 1, 2016, and Sept. 1, 2020, depending on the average daily aggregate notional amount of non-cleared swaps, non-cleared security-based swaps, foreign exchange forwards, and foreign exchange swaps of the covered swap entity and its counterparty for March, April, and May of that year.

Community banks. In its memorandum, the FDIC staff noted “the final rule likely would have minimal impact on community banks or thrifts” since “community banks will not engage in swap activity to the level necessary to meet the rule’s definition of covered swap entity.” The memorandum added that the TRIPRA amendments to the Dodd-Frank swap provisions excludes community bank with total assets of $10 billion or less from the final rule provided the community bank enters into a swap with a covered swap entity to hedge or mitigate commercial risk.

Mindful of costs. During its board meeting, the FDIC Chairman Martin J. Gruenberg stated, “The agencies are mindful of the costs associated with implementing new rules and regulations. Like the proposed rule, the margin requirements of the final rule will apply to new, non-cleared swaps entered into after the rule's effective dates. The rule will not be applied retroactively. In addition, the threshold for financial end users impacted by the rule was increased from $3 billion of notional derivatives exposure in the proposal to $8 billion in the final rule.”

Balanced. The FDIC’s Vice Chairman, Thomas M. Hoenig, added, “the final rule does a good job of balancing the market’s need to compete and take risk, with the broader goal of managing risk and assuring financial stability.”

MainStory: TopStory BankingOperations CapitalBaselAccords DoddFrankAct FinancialStability PrudentialRegulation SecuritiesDerivatives

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