SEC may allow wider cross-margining of single-name CDS

Banks are pressing US regulators to permit cross-margining of single-name credit default swaps (CDS) against not only CDS indexes but also cash products and options. 

“The industry has asked to be allowed to cross-margin a broad range of products, including SEC- and CFTC-regulated cleared and uncleared derivatives,” says a regulatory expert at a large investment bank.

That request is said to have a strong chance of being granted. 

The expansion of cross-margining is expected to be part of the Securities and Exchange Commission’s proposed rules for security-based swaps, which was first drafted in 2013 but never put to vote. The Commodity Futures Trading Commission finalised its rules for CDS indexes in 2012. 

Market participants are hopeful the proposal will be put to a vote in the coming months. However, some are questioning whether the SEC can finalise the rules – which were reopened in October 2018 for additional comment – without re-proposing them, given the changes have been incorporated since 2012. 

There have been some positive signs though. Outgoing CFTC Chairman Christopher Giancarlo told the House Agriculture Committee on May 1 that the SEC would soon be taking action on capital, margin and segregation rules for uncleared derivatives.

“You will see some action on that, with a bit of luck even before I leave the commission,” he said. “But, certainly sometime this summer, I imagine those will be finalised.”

Harmonising rules

The upcoming SEC rules could end the uncertainty over the regulatory treatment of cleared CDS indexes and single names.

After the CFTC finalised its clearing mandate for CDS indexes, banks and buy-side firms realised they could no longer cross-margin single names with CDS indexes in CFTC-regulated margin accounts. That would have resulted in huge margin hikes for firms that traded single names against the indexes.

To offset that, the SEC released an exemptive order, allowing futures commission merchants (FCMs) and broker dealers to commingle and portfolio margin customer positions in cleared CDS contracts in a single segregated account. Customers could receive the benefit of cross-margining single-name CDS against indexes under CFTC rules.

Since then, buy-side firms have been voluntarily clearing single names alongside indexes under the order, and dealers say the system has been ticking over nicely.

This release may be pushing the bounds of what is permissible under the APA and the securities laws

Julian Hammar, Morrison & Foerster

According to CFTC data, the volume of swaps cleared on behalf of clients exceeded those cleared by banks on their own account for the first time in January.

In its 2018 re-proposal, the SEC hinted that it would not only preserve the portfolio margining relief afforded in its 2012 exemptive order in the regulation but also widen its application. “Portfolio margining may help to improve cash flows and liquidity, and reduce volatility,” the 2018 document says.

In the re-proposed rule, the SEC asks if it should allow the commingling of swaps and security-based swaps in margin accounts for portfolio margining. It then asks if these instruments should be commingled in accounts with cash instruments and listed options positions in four different scenarios.

The scenarios present a much broader application of portfolio margining than allowed by the exemptive order, says Julian Hammar, a lawyer with Morrison & Foerster and a former assistant general counsel at the CFTC.

“The SEC, in their 2018 release, asked questions about portfolio margining that would expand beyond the 2012 order,” says Hammar. “This would apply to security-based swaps, but they are asking about entities that are security-based swap dealers and swap dealers and other entities. So if they went through with the rules based on this reopened proposal it could be quite a bit broader than the current order.”

Whatever the SEC does on its side to facilitate portfolio margining, the CFTC will have to mirror it, as was the case with the 2012 exemption. Giancarlo said in the House hearing that the CFTC and SEC have achieved “unprecedented levels of co-operation” under his term, including on these particular rules.

The CFTC and SEC have delegated commissioners Brian Quintenz and Hester Peirce, respectively, to the task of aligning their regulations.

“We have been working with the SEC to bring their rule set closer to where ours are, so when they go final with it, it’s much more harmonious,” said Giancarlo.

Legal hurdle?

A crucial question remains, however: because the 2018 proposal was reopened with some significant differences, could the commission legally go ahead with a final rule, rather than having to re-propose it? The Administrative Procedures Act (APA) demands that a final rule must not differ too significantly from its proposal.

“This release may be pushing the bounds of what is permissible under the APA and the securities laws, which require the SEC to consider whether proposed rules will promote competition, efficiency and capital formation; it contains substantive new policy, including rule text, that is more akin to what you would find in a re-proposal without the required analysis,” says Hammar.

At the open meeting in 2018, where the SEC voted to reopen the proposal, then-commissioner Kara Stein was the only vote against. Stein said at the time that the action amounted to stealth rulemaking, as the proposal contained what amounted to new rulemaking, particularly around the portfolio margining questions.

She also expressed concern that the commingling of swaps in margin accounts could complicate bankruptcy and resolution proceedings if confusion arose about who was owed what.

Hammar says it is certainly possible that the SEC could finalise the rules by the summer, but it would be better to re-propose them.

“It’s a bit unusual, this reopening of the comment period,” says Hammar. “Typically, the reopening of a comment period is a very pro forma type of thing, to allow for an extension of time because, for example, the public needs more time to comment on a complex proposal. An agency might ask some additional questions, but it’s usually limited to that.”