Consistent with a final rule issued by the Commodity Future Trading Commission last year (the "IM Segregation Rule"),1 registered swap dealers have begun to notify counterparties prior to the execution of uncleared swaps that counterparties may require that any initial margin be "segregated," that is, held at an independent custodian in an individual account separate from margin posted by other swap dealer counterparties.
Generally, pursuant to the IM Segregation Rule, a swap dealer must notify a counterparty2 that the counterparty may require segregation of initial margin for an uncleared swap either: (i) prior to the execution of each swap; or (ii) once per calendar year. This notice also must identify one or more custodians3 as an acceptable depository for segregated initial margin and provide information (if available) regarding the pricing of segregation with each such custodian.4 The swap dealer may not confirm the terms of any uncleared swap until obtaining the counterparty's election as to whether segregation is required.5 If a counterparty receives a segregation rights notice for a specific calendar year, it may, after making its election, notify the swap dealer that it wishes to change its election, and such changed election will be applicable to swaps entered into thereafter.6
Swap dealers have been required to provide segregation rights notices for initial margin to each "new counterparty" (i.e., a counterparty with which no agreement concerning uncleared swaps — such as an ISDA Master Agreement — existed between the swap dealer and that counterparty as of January 6, 2014) since May 5, 2014. However, such notices must be provided to each "existing counterparty" (i.e., a counterparty with which an agreement concerning uncleared swaps — such as an ISDA Master Agreement — existed between the swap dealer and that counterparty as of January 6, 2014) beginning November 3, 2014.
Requiring segregation of initial margin generally provides a counterparty with a stronger claim to that margin upon an insolvency or other bankruptcy event affecting the swap dealer. This is because the posted collateral is held separately and is identifiable and, also, the swap dealer is unable to reuse posted cash or re-hypothecate posted securities. However, segregation may require custodial fees for which the counterparty is responsible and, possibly, higher transaction fees charged by the swap dealer. Hence, when electing whether to require the segregation of initial margin for uncleared swaps, an end-user should balance the risk of the swap dealer's bankruptcy against possible increased fees.
Footnotes
1 Protection of Collateral of Counterparties to Uncleared Swaps; Treatment of Securities in a Portfolio Margining Account in a Commodity Bankruptcy, 78 Fed. Reg. 66,621 (November 6, 2013). Note that the rules pursuant to which swap dealers must collect initial margin in connection with uncleared swaps are expected to be finalized later this year.
2 The notice must be provided to the counterparty's officer who is responsible for the management of collateral, or, if none, to the counterparty's Chief Risk Officer, or, if none, to the counterparty's Chief Executive Officer, or, if none, to the highest-level decision-maker of the counterparty.
3 The custodian must be independent of both the swap dealer and the counterparty, and segregated initial margin must be designated and held in an account segregated for and on behalf of the counterparty. If the swap dealer and the counterparty agree, then the same account also may hold variation margin. 17 C.F.R. § 23.702(b).
4 17 C.F.R. § 23.701(a).
5 17 C.F.R. § 23.701(d).
6 17 C.F.R. § 23.701(f).
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