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The Dodd-Frank Act’s “Prudential” Margin Requirements

April 25, 2011

In accordance with the Dodd-Frank Act, the Federal Reserve Board, Farm Credit Administration, FDIC, Federal Housing Finance Agency, and the OCC (the “Prudential Regulators”), have jointly proposed rules establishing margin and capital requirements for certain swap dealers, major swap participants, security-based swap dealers, and major security-based swap participants (collectively, “swap entities”).

Who is Affected

The proposed rule would require swap entities regulated by one of the five agencies to collect initial margin and variation margin from counterparties to swaps and security-based swaps that are not cleared through a clearing agency. Swaps and security-based swaps that are not cleared through a clearing agency are known as “non-cleared” swaps. The amount of margin that would be required under the proposed rule would vary based on the relative risk of the counterparty and of the swap or security-based swap. A swap entity would not be required to collect margin from a commercial end user as long as its margin exposure is below an appropriate credit exposure limit established by the swap entity.

Approach

The Prudential Regulators have adopted a risk-based approach to set margin requirements. The proposed rule takes into account the relative risk of a covered swap entity’s activities in establishing both: (i) the minimum amount of initial and variation margin that it must collect from its counterparties; and (ii) the frequency with which a covered swap entity must calculate and collect variation margin from its counterparty.

In implementing this risk-based approach, the proposed rule distinguishes among four separate types of derivatives counterparties: (i) counterparties that are themselves swap entities; (ii) counter-parties that are high-risk financial end users of derivatives; (iii) counterparties that are low-risk financial end users of derivatives; and (iv) counterparties that are nonfinancial end users of derivatives. The proposed rule’s initial and variation margin requirements generally apply only to the collection of minimum margin amounts by a covered swap entity from its
counterparties; they do not contain specific requirements as to the amount of initial or variation margin that a covered swap entity must post to its counterparties.

The proposed rule also requires a covered swap entity to ensure that its counterparty segregates the initial margin that the covered swap entity posts when engaging in swap or security-based swap transactions with another swap entity. The segregation requirement would be mandatory for swap transactions by a covered swap entity with another swap entity.

Timing

While the proposed margin requirements would apply only to swap and security-based swap transactions entered into on or after the date on which the proposed rule becomes effective, the agencies recognize that the requirements could have retroactive effects. The proposed rule therefore requests comment on that issue.

End-Users

The Prudential Regulators believe the Dodd-Frank Act requires all non-cleared swaps to be subject to margin requirement regardless of whether the counter-party is a commercial end user. They recognize, however, that end users generally pose less risk than other counter-parties. They have therefore adopted a tiered approach for commercial end users based on credit exposure limits.

Capital Requirements

The Dodd-Frank Act requires the Prudential Regulators to issue joint rules on capital for the swap entities they regulate. Since the Prudential Regulators already have regulatory capital rules, the agencies are proposing to rely on the existing rules.

Comments should be submitted on or before June 24, 2011. View the proposed rule here.

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