CFTC frees amended legacy swaps from margin net

US no-action relief for compression-triggered replacement trades spurs hope for EU alignment

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US derivatives regulator takes steps to ensure legacy swaps are not caught

The US derivatives regulator has taken steps to ensure legacy swaps are not swept into scope for non-cleared margin rules as a result of certain amendments and lifecycle events, which technically create new instruments that could be subject to costly collateralisation requirements.

The no-action relief issued by the Commodity Futures Trading Commission (CFTC) on June 6 brings the US approach closer in line with accepted interpretation of the treatment of amended legacy instruments under the European Market Infrastructure Regulation (Emir).

For example, the European regulations make exempt from the margin rules any swaps resulting from the exercise of a swaption written before the relevant margin requirement entered into force. The US goes a step further by providing explicit relief for replacement trades resulting from multilateral compression activity.

According to Matthew Kulkin, director of the CFTC’s department of swap dealer and intermediary oversight, the latest relief creates certainty with respect to several amendments and lifecycle events that swap dealers encounter routinely in swap portfolios with counterparties.

“Further, the relief for swaps resulting from compression of legacy swap portfolios will permit swap dealers to proceed with an important risk management function,” Kulkin said in a statement. 

Under the relief, five types of activity would allow swaps to retain their legacy status, thereby exempting amended or replaced trades from regulatory margin requirements in cases where the initial trade was struck before the applicable compliance date for non-cleared margin rules.

The first activity, immaterial amendments, refers to any change in terms that would not affect the economic obligations of the parties or the valuation of the swap. In a footnote, the CFTC says any extension to the maturity or termination date of a legacy instrument would always affect the economic obligations and valuation, meaning such a change would bring the instrument into scope for margin posting.

The definition of “immaterial” remains a grey area, according to industry lawyers. For example, while a multiple times increase in the notional outstanding of a swap would unquestionably be treated as a material change, it is not clear whether a marginal, single-digit percentage increase would bring a legacy trade into scope for regulatory initial margin (IM).

“It may depend on the context, but if there’s a valid reason for the adjustment and it wasn’t just to get larger exposure – for example, if there was some rebalancing going on – I’d have thought you could take the view that it is not a new transaction,” says Pauline Ashall, derivatives partner at Linklaters in London.

Other changes addressed in the letter are less hazy. For example, any remaining stub of a partially terminated or partially novated swap retains legacy status, although the novated part itself would be treated as a new instrument and subject to margin requirements.

I think this is very helpful from the point of view of trying to get a favourable view from the European Commission, European Council and Parliament to say they’re bringing it into line with what’s now practice in the US
Pauline Ashall, Linklaters

Additionally, swaps resulting from the exercise of a swaption would also be deemed legacy instruments, providing the original options contract was struck prior to the margin compliance date. In the letter, the CFTC notes such relief would not be available for participants who entered into large volumes of swaptions prior to the applicable IM compliance date with the specific intention of evading collateral requirements.

These four clarifications bring the US approach closer in line with the current consensus in the European Union. The European view on margin relief is extrapolated from guidance provided by the European Securities and Markets Authority, which exempts from mandatory clearing under Emir certain amended trades and swaps resulting from swaptions exercise. 

Compression released

Where the US approach now differs from the European interpretation is in the treatment of amended and replacement swaps issued as a result of compression activity, aimed at reducing operational or counterparty credit risk. To qualify for the CFTC’s margin relief, replacement or amended swaps must have the same material terms as the original trades, with changes limited to the notional amount.

This change has created a cross-border mismatch. If counterparties located in the US and Europe opt to compress a portfolio of trades, a European counterparty would see the resulting replacement swaps subject to regulatory IM, while the US counterparty would not.

When discussing revisions to Emir, dubbed Emir Refit, the European Parliament and Council of the EU considered adding a carve-out from the clearing obligation for instruments issued as a result of risk-reducing activities such as compression. In the final version of the legislation, however, those plans were dropped, with lawmakers opting for a review of the situation after 18 months.

Market participants are concerned that, by slapping regulatory requirements such as mandatory clearing and margining on risk reduction activities, regulators may be hampering the take-up of services aimed at helping market participants to cut risk-weighted assets and reduce margin requirements.

The CFTC’s no-action letter cites a request from the International Swaps and Derivatives Association, in which the industry body argued: “Because participants would not know in advance which swaps may be subject to an amendment or replacement, or the notional amount to be amended or replaced, market participants likely would reconsider their participation in these industrywide risk-reduction exercises.”

Lawyers hope the latest US move bodes well for the chance of a similar exemption under Emir.

“I think this is very helpful from the point of view of trying to get a favourable view from the European Commission, European Council and Parliament to say they’re bringing it into line with what’s now practice in the US,” says Ashall.

Libor escape route

The move could also pave the way for a blanket ruling to permit legacy swaps to be converted from Libor to overnight risk-free rates without triggering mandatory clearing or non-cleared margin requirements.

Initial margin rules have been implemented in five annual waves out to 2020. The largest dealers with non-cleared swaps exposures of $3 trillion or more began posting margin on their bilateral portfolios in September 2016. Around 50 firms are now subject to the rules, including the first buy-side firm, Brevan Howard, which was brought into scope in 2018.   

Another 42 entities will be added in September this year, when phase four extends the rules to firms with non-cleared derivatives exposures of $750 billion. The fifth and final phase in September 2020, the so-called IM big bang, will see the compliance threshold plummet to just $8 billion, bringing into scope a further 641 (primarily buy-side) firms, according to analysis by BNY Mellon.

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