On October 13, 2017, the US Commodity Futures Trading Commission (CFTC) and the European Commission (EC) voted in favor of margin rules equivalency, recognizing that margin regimes operating in the US[i] and the EU[ii] are comparable in outcome. The Wall Street Journal rushed to interpret the agreement as enabling ‘US and European firms to follow home region rules while doing business across the Atlantic’. Essentially, the fact that the two ‘competing’ regulators reached an agreement on how margin regimes apply on pan-jurisdictional level is an undeniably positive outcome for international businesses. It is indeed an important first step in harmonizing the two legal frameworks, bringing both jurisdictions closer to the goal of ‘maintaining the integrity of our [international] swaps market’. However, the practical benefits of this recently declared equivalency for financial firms might be hindered by the high costs of assessing whether the relief is available. In the US, a substituted compliance regime allows covered swap entities to follow alternative EU margin rules when transacting in non-centrally cleared OTC swaps. In the EU, equivalency does not grant a complete relief of substituted compliance, providing for partial equivalence instead.
In a nutshell
Both the CFTC and EU margin rules were designed within the BCBS/IOSCO international margin framework and have the common objective of reducing systemic risks by ensuring that collateral is available to offset losses associated with non-centrally cleared derivatives, as well as preventing a new financial crisis. Despite these commonalities, there has been substantial divergence between the two regimes. The discrepancies have invoked criticism among market participants with cross-border derivatives business, which have complained about the high compliance costs of adherence to different margin regimes operating internationally.
US: substituted compliance with carve-outs
The effect of the comparability determination is most prominent in the US, where the CFTC has introduced substituted compliance for American swap entities registered with, and subject to, CTFC jurisdiction. As expressly provided by the CFTC Comparability Determination, such firms can choose to comply with the European margin rules and thus be deemed to be adhering to their CFTC equivalents. The availability of the substituted compliance regime is limited, however, and depends on the following conditions:
- Prudentially regulated entities are out-of-scope. The Comparability Determination holds that the substituted compliance regime extends to those CFTC-regulated financial firms for which there is not a Prudential Regulator. Thus, all entities subject to both the CFTC margin framework and the Prudential Regulators’ margin rules cannot rely on the exemption.
- In-scope entities subject to both the CFTC and the EC margin framework can rely on substituted compliance. The new framework is available to all covered swap entities subject to the CFTC margin rules and to the EU’s margin rules. For instance, an American subsidiary of a European investment firm may trade uncleared swaps with an Australian bank. If the subsidiary is a swap dealer/major swap participant registered with the CFTC, as well as falling within the definition of a counterparty regulated by the EU, the entity can rely on substituted compliance and choose to comply with the Regulatory Technical Standards of EMIR instead of the CFTC’s margin rules.
- The relief is available for in-scope products only, i.e. non-centrally cleared derivatives/swaps subject to margining under both the EU and CFTC’s margin rules. In other words, a transaction which is subject to margining as a ‘non-centrally cleared OTC derivative’ under EU law and as an ‘uncleared swap’ under the CFTC’s margin rules creates eligibility for substituted compliance. A point to note is that several types of derivatives instruments will fall out of the scope of substituted compliance upon the implementation of MiFID II. FX swaps and forwards trading in the EU will be subject to variation margin exchange in early 2018, and, therefore, parties trading physically settled FX products will have to comply with both the CFTC’s and the EC’s margin rules.
Once the above conditions are satisfied, the parties can enjoy the benefit of complete equivalence in all aspects of the two margin regimes. They have a choice whether to adopt the CFTC’s or EU’s margin rules, and adherence to the EU framework provides an exemption from margining under the CFTC regime.
EU: limited equivalence
In the EU, the equivalence has a more limited application; it does not give rise to a substituted compliance regime analogous to that introduced by the CFTC. Instead, equivalence is recognized in the following elements of the margin rules:
- Material swaps exposure/initial margin (IM) threshold. Under both regimes, initial margin exchange is conditioned on the counterparties exceeding the materiality threshold of $8 billion (in the US) or EUR 8 billion (in the EU) in the average daily notional value of non-cleared OTC derivatives. These amounts are deemed equivalent by the regulators, and compliance with either threshold will suffice.
- Minimum transfer amount (MTA). A combined MTA of initial and variation margin is set at $500,000 in the US and EUR 500,000 in the EU. Those amounts are also considered equivalent.
- Eligible collateral. The regulators recognize the equivalency of the list of eligible collateral, as well as the way it is held and segregated.
- IM calculation. The requirements for IM calculation by way of the use of SIMM (standardized initial margin model), internal and third party models are deemed equivalent in both jurisdictions.
In sum, the equivalence determination made by the EC and the CFTC is not all-encompassing, and contains caveats which may preclude trading counterparties from relying on one regime to the exclusion of another. It is also worth noting that substituted compliance is a one-way street – it only provides leeway to a subset of firms subject to both the US and EU margin frameworks, allowing them to rely on the EU’s (at times less restrictive) margin rules in lieu of the CFTC’s regime. It does not work the other way round: the EU has not provided reciprocal relief to EU-regulated entities, and CFTC-margin-compliant European firms will still be subject to EMIR.
Whether this recent regulatory attempt to create an international margin framework for non-centrally cleared OTC derivatives will be successful and will result in practical benefits for asset managers and other investment firms has yet to be seen. Financial firms seem to have a choice between preserving the status quo in margining their relationships or using the American substituted compliance model. In case of the former, it is anticipated that firms will continue to take a conservative approach and choose the strictest elements of each margin regime applicable to their derivatives business. On the upside, the EC has simplified the task of reconciling the two regimes by clarifying some, but not all, of the apparent discrepancies in the rules. If the latter approach prevails, firms will have to set aside additional costs to determine whether substituted compliance relief is available and can be applied to their trading relationships. In this case, the assessment will need to be broken down not only by trading entities, but also by the type of OTC derivatives/swaps in question. It remains to be seen whether the declared equivalence will result in substantial cost savings for the industry, as determining whether substituted compliance applies is itself a costly exercise.
[i] See Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 81 FR 636 (Jan. 6, 2016). Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants – Cross-Border Application of the Margin Requirements, 81 FR 34818 (May 31, 2016)
[ii] See Regulation No. 2016/2251 of October 4, 2016 Supplementing Regulation (EU) No 648/2012 of the European Parliament and Council of July 4, 2012 on OTC Derivatives, CCP and Trade Repositories with Regard to RTS for Risk-Mitigation Techniques for OTC Derivative Contracts Not Centrally Cleared by a CCP (as corrected by Commission Delegated Regulation (EU) 2017/323 of January 20, 2017).