Margin and Capital Requirements for Covered Swap Entities

Federal RegisterMay 11, 2011

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DEPARTMENT OF THE TREASURY

Office of the Comptroller of the Currency

12 CFR Part 45

[Docket No. OCC-2011-0008]

RIN 1557-AD43

BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM

12 CFR Part 237

[Docket No. R-1415]

RIN 7100 AD74

FEDERAL DEPOSIT INSURANCE CORPORATION

12 CFR Part 324

RIN 3064-AD79

FARM CREDIT ADMINISTRATION

12 CFR Part 624

RIN 3052-AC69

FEDERAL HOUSING FINANCE AGENCY

12 CFR Part 1221

RIN 2590-AA45

Margin and Capital Requirements for Covered Swap Entities

AGENCY:

Office of the Comptroller of the Currency, Treasury (OCC); Board of Governors of the Federal Reserve System (Board); Federal Deposit Insurance Corporation (FDIC); Farm Credit Administration (FCA); and the Federal Housing Finance Agency (FHFA).

ACTION:

Notice of proposed rulemaking.

SUMMARY:

The OCC, Board, FDIC, FCA, and FHFA (collectively, the Agencies) are requesting comment on a proposal to establish minimum margin and capital requirements for registered swap dealers, major swap participants, security-based swap dealers, and major security-based swap participants for which one of the Agencies is the prudential regulator. This proposed rule implements sections 731 and 764 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which require the Agencies to adopt rules jointly to establish capital requirements and initial and variation margin requirements for such entities on all non-cleared swaps and non-cleared security-based swaps in order to offset the greater risk to such entities and the financial system arising from the use of swaps and security-based swaps that are not cleared.

DATES:

Comments should be received on or before June 24, 2011.

ADDRESSES:

Interested parties are encouraged to submit written comments jointly to all of the Agencies. Commenters are encouraged to use the title “Margin and Capital Requirements for Covered Swap Entities” to facilitate the organization and distribution of comments among the Agencies. Commenters are also encouraged to identify the number of the specific question for comment to which they are responding.

Office of the Comptroller of the Currency:

Because paper mail in the Washington, DC area and at the OCC is subject to delay, commenters are encouraged to submit comments by the Federal eRulemaking Portal or e-mail, if possible. Please use the title “Margin and Capital Requirements” to facilitate the organization and distribution of the comments. You may submit comments by any of the following methods:

•

Federal eRulemaking Portal—“Regulations.gov”:

Go to

http://www.regulations.gov.

Select “Document Type” of “Proposed Rules,” and in the “Enter Keyword or ID Box,” enter Docket ID “OCC-2011-0008,” and click “Search.” On “View By Relevance” tab at the bottom of screen, in the “Agency” column, locate the Proposed Rule for the OCC, in the “Action” column, click on “Submit a Comment” or “Open Docket Folder” to submit or view public comments and to view supporting and related materials for this rulemaking action.

• Click on the “Help” tab on the Regulations.gov home page to get information on using Regulations.gov, including instructions for submitting or viewing public comments, viewing other supporting and related materials, and viewing the docket after the close of the comment period.

•

E-mail: regs.comments@occ.treas.gov.

•

Mail:

Office of the Comptroller of the Currency, 250 E Street, SW., Mail Stop 2-3, Washington, DC 20219.

•

Fax:

(202) 874-5274.

•

Hand Delivery/Courier:

250 E Street, SW., Mail Stop 2-3, Washington, DC 20219.

Instructions:

You must include “OCC” as the agency name and “Docket ID OCC-2011-0008” in your comment. In general, OCC will enter all comments received into the docket and publish them on the Regulations.gov Web site without change, including any business or personal information that you provide such as name and address information, e-mail addresses, or phone numbers. Comments received, including attachments and other supporting materials, are part of the public record and subject to public disclosure. Do not enclose any information in your comment or supporting materials that you consider confidential or inappropriate for public disclosure.

You may review comments and other related materials that pertain to this proposed rulemaking by any of the following methods:

•

Viewing Comments Electronically:

Go to

http://www.regulations.gov.

Select “Document Type” of “Public Submissions,” and in the “Enter Keyword or ID Box,” enter Docket ID “OCC-2011-0008,” and click “Search.” Comments will be listed under “View By Relevance” tab at the bottom of screen. If comments from more than one agency are listed, the “Agency” column will indicate which comments were received by the OCC.

•

Viewing Comments Personally:

You may personally inspect and photocopy comments at the OCC, 250 E Street, SW., Washington, DC. For security reasons, the OCC requires that visitors make an appointment to inspect comments. You may do so by calling (202) 874-4700. Upon arrival, visitors will be required to present valid government-issued photo identification and submit to security screening in order to inspect and photocopy comments.

•

Docket:

You may also view or request available background documents and project summaries using the methods described above.

Board of Governors of the Federal Reserve System

You may submit comments, identified by Docket No. R-1415 and RIN 7100 AD74, by any of the following methods:

•

Agency Web Site: http://www.federalreserve.gov.

Follow the instructions for submitting comments at

http://www.federalreserve.gov/generalinfo/foia/ProposedRegs.cfm.

•

Federal eRulemaking Portal: http://www.regulations.gov.

Follow the instructions for submitting comments.

•

E-mail: regs.comments@federalreserve.gov.

Include the docket number in the subject line of the message.

•

Fax:

(202) 452-3819 or (202) 452-3102.

•

Mail:

Address to Jennifer J. Johnson, Secretary, Board of Governors of the Federal Reserve System, 20th Street and Constitution Avenue, NW., Washington, DC 20551.

All public comments will be made available on the Board's Web site at

http://www.federalreserve.gov/generalinfo/foia/ProposedRegs.cfm

as submitted, unless modified for technical reasons. Accordingly, comments will not be edited to remove any identifying or contact information. Public comments may also be viewed electronically or in paper in Room MP-500 of the Board's Martin Building (20th and C Streets, NW.) between 9 a.m. and 5 p.m. on weekdays.

Federal Deposit Insurance Corporation:

You may submit comments, identified by RIN number, by any of the following methods:

•

Agency Web Site: http://www.fdic.gov/regulations/laws/federal/propose.html.

Follow instructions for submitting comments on the Agency Web site.

•

E-mail: Comments@FDIC.gov.

Include the RIN number on the subject line of the message.

•

Mail:

Robert E. Feldman, Executive Secretary, Attention: Comments, Federal Deposit Insurance Corporation, 550 17th Street, NW., Washington, DC 20429.

•

Hand Delivery:

Comments may be hand delivered to the guard station at the rear of the 550 17th Street Building (located on F Street) on business days between 7 a.m. and 5 p.m.

Instructions:

All comments received must include the agency name and RIN for this rulemaking and will be posted without change to

http://www.fdic.gov/regulations/laws/federal/propose.html,

including any personal information provided.

Federal Housing Finance Agency:

You may submit your written comments on the proposed rulemaking, identified by regulatory information number (RIN) 2590-AA45, by any of the following methods:

•

E-mail:

Comments to Alfred M. Pollard, General Counsel, may be sent by e-mail at

RegComments@fhfa.gov.

Please include “RIN 2590-AA45” in the subject line of the message.

•

Federal eRulemaking Portal: http://www.regulations.gov.

Follow the instructions for submitting comments. If you submit your comment to the Federal eRulemaking Portal, please also send it by e-mail to FHFA at

RegComments@fhfa.gov

to ensure timely receipt by the Agency. Please include “RIN 2590-AA45” in the subject line of the message.

•

U.S. Mail, United Parcel Service, Federal Express, or Other Mail Service:

The mailing address for comments is: Alfred M. Pollard, General Counsel, Attention: Comments/RIN 2590-AA45, Federal Housing Finance Agency, Fourth Floor, 1700 G Street, NW., Washington, DC 20552.

•

Hand Delivery/Courier:

The hand delivery address is: Alfred M. Pollard, General Counsel, Attention: Comments/RIN 2590-AA45, Federal Housing Finance Agency, Fourth Floor, 1700 G Street, NW., Washington, DC 20552. A hand-delivered package should be logged at the Guard Desk, First Floor, on business days between 9 a.m. and 5 p.m.

All comments received by the deadline will be posted for public inspection without change, including any personal information you provide, such as your name and address, on the FHFA Web site at

http://www.fhfa.gov.

Copies of all comments timely received will be available for public inspection and copying at the address above on government-business days between the hours of 10 a.m. and 3 p.m. To make an appointment to inspect comments please call the Office of General Counsel at (202) 414-6924.

Farm Credit Administration:

We offer a variety of methods for you to submit your comments. For accuracy and efficiency reasons, commenters are encouraged to submit comments by e-mail or through the FCA's Web site. As facsimiles (fax) are difficult for us to process and achieve compliance with section 508 of the Rehabilitation Act, we are no longer accepting comments submitted by fax. Regardless of the method you use, please do not submit your comments multiple times via different methods. You may submit comments by any of the following methods:

•

E-mail:

Send us an e-mail at

reg-comm@fca.gov.

•

FCA Web site: http://www.fca.gov.

Select “Public Commenters,” then “Public Comments,” and follow the directions for “Submitting a Comment.”

•

Federal eRulemaking Portal: http://www.regulations.gov.

Follow the instructions for submitting comments.

•

Mail:

Gary K. Van Meter, Acting Director, Office of Regulatory Policy, Farm Credit Administration, 1501 Farm Credit Drive, McLean, VA 22102-5090.

You may review copies of all comments we receive at our office in McLean, Virginia or on our Web site at

http://www.fca.gov.

Once you are in the Web site, select “Public Commenters,” then “Public Comments,” and follow the directions for “Reading Submitted Public Comments.” We will show your comments as submitted, including any supporting data provided, but for technical reasons we may omit items such as logos and special characters. Identifying information that you provide, such as phone numbers and addresses, will be publicly available. However, we will attempt to remove e-mail addresses to help reduce Internet spam.

FOR FURTHER INFORMATION CONTACT:

OCC:

Michael Sullivan, Market RAD (202) 874-3978, Kurt Wilhelm, Director, Financial Markets Group (202) 874-4479, Jamey Basham, Assistant Director, Legislative and Regulatory Activities Division (202) 874-5090, or Ron Shimabukuro, Senior Counsel, Legislative and Regulatory Activities Division (202) 874-5090, Office of the Comptroller of the Currency, 250 E Street, SW., Washington, DC 20219.

Board:

Sean D. Campbell, Deputy Associate Director, Division of Research and Statistics, (202) 452-3761, Michael Gibson, Senior Associate Director, Division of Research and Statistics, (202) 452-2495, or Jeremy R. Newell, Senior Attorney, Legal Division, (202) 452-3239, Board of Governors of the Federal Reserve System, 20th and C Streets, NW., Washington, DC 20551.

FDIC:

Bobby R. Bean, Chief, Policy Section, (202) 898-6705, John Feid, Senior Capital Markets Specialist, (202) 898-8649, Division of Risk Management Supervision, Thomas F. Hearn, Counsel, (202) 898-6967, or Ryan K. Clougherty, Senior Attorney, (202) 898-3843, Legal Division, Federal Deposit Insurance Corporation, 550 17th Street, NW., Washington, DC 20429.

FHFA:

Robert Collender, Principal Policy Analyst, Office of Policy Analysis and Research, (202) 343-1510,

Robert.Collender@fhfa.gov,

Peggy Balsawer, Assistant General Counsel, Office of General Counsel, (202) 343-1529,

Peggy.Balsawer@fhfa.gov.

or James Carley, Senior Associate Director, Division of FHLBank Regulation, (202) 408-2507,

James.Carley@fhfa.gov,

Federal Housing Finance Agency, Fourth Floor, 1700 G Street, NW., Washington, DC 20552. The telephone number for the Telecommunications Device for the Hearing Impaired is (800) 877-8339.

FCA:

William G. Dunn, Acting Associate Director, Finance and Capital Markets Team, Office of Regulatory Policy, Farm Credit Administration, McLean, VA 22102-5090, (703) 883-4414, TTY (703) 883-4434, Joseph T. Connor, Associate Director for Policy and Analysis, Office of Secondary Market Oversight, Farm Credit Administration, McLean, VA 22102-5090, (703) 883-4280, TTY (703) 883-4434, or Rebecca S. Orlich, Senior Counsel, Office of General Counsel, Farm Credit Administration, McLean, VA 22102-5090, (703) 883-4020, TTY (703) 883-4020.

SUPPLEMENTARY INFORMATION:

I. Background

The Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act) was enacted on July 21, 2010.

Title VII of the Dodd-Frank Act established a comprehensive new regulatory framework for derivatives, which the Act generally characterizes as “swaps” (which are defined in section 721 of the Dodd-Frank Act to include interest rate swaps, commodity-based swaps, and broad-based credit swaps) and “security-based swaps” (which are defined in section 761 of the Dodd-Frank Act to include single-name and narrow-based credit swaps and equity-based swaps).

Dodd-Frank Wall Street Reform and Consumer Protection Act, Public Law 111-203, 124 Stat. 1376 (2010).

See

7 U.S.C. 1a(47); 15 U.S.C. 78c(a)(68). Swaps and security-based swaps are sometimes referred to herein collectively as “derivatives.”

As part of this new regulatory framework, sections 731 and 764 of the Dodd-Frank Act add a new section 4s to the Commodity Exchange Act and a new section 15F to the Securities Exchange Act of 1934, respectively, which require the registration and regulation of swap dealers and major swap participants and security-based swap dealers and major security-based swap participants (collectively, swap entities).

For certain types of swap entities that are prudentially regulated by one of the Agencies,

sections 731 and 764 of the Dodd-Frank Act require the Agencies to adopt rules jointly for swap entities under their respective jurisdictions imposing (i) capital requirements and (ii) initial and variation margin requirements on all non-cleared swaps and non-cleared security-based swaps.

Swap entities that are prudentially regulated by the Agencies and therefore subject to the proposed rule are referred to herein as “covered swap entities.”

See

7 U.S.C. 6s; 15 U.S.C. 78

-8. Section 731 of the Dodd-Frank Act requires swap dealers and major swap participants to register with the Commodity Futures Trading Commission (the “CFTC”), which is vested with primary responsibility for the oversight of the swaps market under title 7 of the Dodd Frank Act. Section 764 of the Dodd-Frank Act requires security-based swap dealers and major security-based swap participants to register with the Securities and Exchange Commission (the “SEC”), which is vested with primary responsibility for the oversight of the security-based swaps market under title 7 of the Dodd-Frank Act. Section 713(d)(1) of the Dodd-Frank Act requires the CFTC and SEC to issue joint rules further defining the terms swap dealer, major swap participant, security-based swap dealer, and major security-based swap participant. The CFTC and SEC issued a joint notice of proposed rulemaking with respect to these definitions in December, 2010.

See

75 FR 80,174 (Dec. 21, 2010) (proposed rule).

Section 1a(39) of the Commodities Exchange Act defines the term “prudential regulator” for purposes of the capital and margin requirements applicable to swap dealers, major swap participants, security-based swap dealers and major security-based swap participants. The Board is the prudential regulator for any swap entity that is (i) a State-chartered bank that is a member of the Federal Reserve System, (ii) a State-chartered branch or agency of a foreign bank, (iii) a foreign bank which does not operate an insured branch, (iv) an organization operating under section 25A of the Federal Reserve Act (an Edge corporation) or having an agreement with the Board under section 25 of the Federal Reserve Act (an Agreement corporation), and (v) a bank holding company, a foreign bank that is treated as a bank holding company under section 8(a) of the International Banking Act of 1978, or a savings and loan holding company (on or after the transfer date established under section 311 of the Dodd-Frank Act), or a subsidiary of such a company or foreign bank (other than a subsidiary for which the OCC or FDIC is the prudential regulator or that is required to be registered with the CFTC or SEC as a swap dealer or major swap participant or a security-based swap dealer or major security-based swap participant, respectively). The OCC is the prudential regulator for any swap entity that is a national bank, a Federally chartered branch or agency of a foreign bank, or a Federal savings association. The FDIC is the prudential regulator for any swap entity that is (i) a State-chartered bank that is not a member of the Federal Reserve System or (ii) a State savings association. The FCA is the prudential regulator for any swap entity that is an institution chartered under the Farm Credit Act of 1971, as amended. FHFA is the prudential regulator for any swap entity that is a “regulated entity” under the Federal Housing Enterprises Financial Safety and Soundness Act of 1992 (

i.e.,

the Federal National Mortgage Association and its affiliates, the Federal Home Loan Mortgage Corporation and its affiliates, and the Federal Home Loan Banks).

See

7 U.S.C. 1a(39).

See

7 U.S.C. 6s(e)(2)(A); 15 U.S.C. 78

-8(e)(2)(A). Section 6(s)(e)(1)(A) directs registered swap dealers and major swap participants for which there is a prudential regulator to comply with margin and capital rules issued by the prudential regulators, while section 6(s)(e)(1)(B) directs registered swap dealers and major swap participants for which there is not a prudential regulator to comply with margin and capital rules issued by the CFTC and SEC. Section 78o-8(e)(1) generally parallels section 6s(e)(1), except that section 78o-8(e)(1)(A) refers to registered security-based swap dealers and major security-based swap participants for which “there is not a prudential regulator.” The Agencies construe the “not” in section 78o-8(e)(1)(A) to have been included by mistake, in conflict with section 78

-8(e)(2)(A), and of no substantive meaning. Otherwise, registered security-based swap dealers and major security-based swap participants for which there is not a prudential regulator could be subject to multiple capital and margin rules, and institutions regulated by the prudential regulators and registered as security-based swap dealers and major security-based swap participants might not be subject to any capital and margin requirements under section 78

-8(e).

Sections 731 and 764 of the Dodd-Frank Act require the CFTC and SEC to separately adopt rules imposing capital and margin requirements for swap entities for which there is no prudential regulator.

The Dodd-Frank Act requires the CFTC, SEC, and the Agencies to establish and maintain, to the maximum extent practicable, capital and margin requirements that are comparable, and to consult with each other periodically (but no less than annually) regarding these requirements.

See

7 U.S.C. 6s(e)(2)(B); 15 U.S.C. 78

-8(e)(2)(B).

See

7 U.S.C. 6s(e)(2)(A); 6s(e)(3)(D); 15 U.S.C. 78

-8(e)(2)(A), 78

-8(e)(3)(D). Staff of the Agencies have consulted with staff of the CFTC and SEC in developing the proposed rule.

The capital and margin standards for swap entities imposed under sections 731 and 764 of the Dodd-Frank Act are intended to offset the greater risk to the swap entity and the financial system arising from the use of swaps and security-based swaps that are not cleared.

Sections 731 and 764 of the Dodd-Frank Act require that the capital and margin requirements imposed on swap entities must, to offset such risk, (i) help ensure the safety and soundness of the swap entity and (ii) be appropriate for the greater risk associated with the non-cleared swaps and non-cleared security-based swaps held as a swap entity.

In addition, Sections 731 and 764 of the Dodd-Frank Act require the Agencies, in establishing capital rules for covered swap entities, to take into account the risks associated with other types, classes or categories of swaps or security-based swaps engaged in, and the other activities conducted by that person that are not otherwise subject to regulation applicable to that person by virtue of the status of the person as a swap dealer or a major swap participant.

Sections 731 and 764 become effective not less than 60 days after publication of the final rule or regulation implementing these sections.

See

7 U.S.C. 6s(e)(3)(A); 15 U.S.C. 78

-8(e)(3)(A).

See

7 U.S.C. 6s(e)(3)(A); 15 U.S.C. 78

-8(e)(3)(A). In addition, Section 1201 of Housing and Economic Recovery Act of 2008 (Pub. L. 110-289, 122 Stat. 2654) requires the Director of FHFA, when promulgating regulations relating to the Federal Home Loan Banks, to consider the following differences between the Federal Home Loan Banks and the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac): cooperative ownership structure; mission of providing liquidity to members; affordable housing and community development mission; capital structure; and joint and several liability.

See

section 1201 Public Law 110-289, 122 Stat. 2782-83 (amending 12 U.S.C. 4513). The Director of FHFA also may consider any other differences that are deemed appropriate. For purposes of this proposed rule, FHFA considered the differences as they relate to the above factors. FHFA requests comments from the public about whether differences related to these factors should result in any revisions to the proposal.

See

7 U.S.C. 6s(e)(2)(C); 15 U.S.C. 78

-8(e)(2)(C). In addition, the margin requirements imposed by the Agencies must permit the use of noncash collateral, as the Agencies determine to be consistent with (i) preserving the financial integrity of the markets trading swaps and security-based swaps and (ii) preserving the stability of the U.S. financial system.

See

7 U.S.C. 6s(e)(3)(C); 15 U.S.C. 78

-8(e)(3)(C).

See

Dodd Frank Act §§ 754, 774.

The capital and margin requirements that must be established with respect to

non-cleared derivatives under sections 731 and 764 of the Dodd-Frank Act complement changes made elsewhere in the Act that require all sufficiently standardized swaps and security-based swaps be cleared through a derivatives clearing organization or clearing agency.

This clearing mandate reflects the consensus of the G-20 leaders: “All standardized over-the-counter derivatives contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end of 2012 at the latest.”

See

7 U.S.C. 2(h); 15 U.S.C. 78c-3. Certain types of counterparties (

e.g.,

counterparties that are not financial entities and are using swaps or security-based swaps to hedge or mitigate commercial risks) are exempt from this mandatory clearing requirement and may elect not to clear a swap or security-based swap that would otherwise be subject to the clearing requirement.

G-20 Leaders, June 2010 Toronto Summit Declaration, ¶ 25. The dealer community has also recognized the importance of clearing—beginning in 2009, in an effort led by the Federal Reserve Bank of New York, the dealer community agreed to increase central clearing for certain credit derivatives and interest rate derivatives.

See

Press Release, Federal Reserve Bank of New York, New York Fed Welcomes Further Industry Commitments on Over-the-Counter Derivatives press release (June 2, 2009),

available at http://www.newyorkfed.org/newsevents/news/markets/2009/ma090602.html.

In the derivatives clearing process, central counterparties (CCPs) manage the credit risk through a range of controls and methods, including a margining regime that imposes both initial margin and variation margin requirements on parties to cleared transactions.

Thus, the mandatory clearing requirement established by the Dodd-Frank Act for swaps and security-based swaps will effectively require any party to any transaction subject to the clearing mandate to post initial and variation margin to the CCP in connection with that transaction.

CCPs interpose themselves between counterparties to a derivative transaction, becoming the buyer to the seller and the seller to the buyer and, in the process, taking on the credit risk that each party poses to the other. For example, when a derivatives contract between two parties that are members of a CCP is executed and submitted for clearing, it is typically replaced by two new contracts—separate contracts between the CCP and each of the two original counterparties. At that point, the original counterparties are no longer counterparties to each other; instead, each faces the CCP as its counterparty, and the CCP assumes the counterparty credit risk of each of the original counterparties.

However, if a particular swap or security-based swap is not cleared because it is not subject to the mandatory clearing requirement (or because one of the parties to a particular swap or security-based swap is eligible for, and uses, an exemption from the mandatory clearing requirement), that swap or security-based swap will be a “non-cleared” swap or security-based swap and will be subject to the capital and margin requirements for such transactions established under sections 731 and 764 of the Dodd-Frank Act.

The comprehensive derivatives-related provisions of title VII of the Dodd-Frank Act, including sections 731 and 764, are intended in general to reduce risk, increase transparency, promote market integrity within the financial system, and, in particular, address a number of weaknesses in the regulation and structure of the derivatives markets that were revealed during the financial crisis experienced in 2008 and 2009. During the financial crisis, the opacity of derivatives transactions among dealer banks and between dealer banks and their counterparties created uncertainty about whether market participants were significantly exposed to the risk of a default by a swap counterparty. By imposing a regulatory margin requirement on non-cleared swaps, the Dodd-Frank Act will reduce the uncertainty around the possible exposures arising from non-cleared swaps.

The recent financial crisis also revealed that some participants in the derivatives markets had used derivatives to take on excessive risks. By imposing a minimum margin requirement on non-cleared derivatives, sections 731 and 764 of the Dodd-Frank Act will reduce the ability of firms to take on excessive risks through swaps without sufficient financial resources to make good on their contracts. Because the Dodd-Frank Act requires that the margin requirements be based on the risks posed by the non-cleared derivatives and derivatives counterparties, firms that take significant risks through derivatives will face more stringent margin requirements with respect to non-cleared derivatives, while firms that take lower risks will face less stringent margin requirements.

II. Overview of Proposed Rule

A. Margin Requirements

The Agencies have generally adopted a risk-based approach in proposing rules to establish initial and variation margin requirements for covered swap entities, consistent with the statutory requirement that these rules help ensure the safety and soundness of the covered swap entity and be appropriate for the risk to the financial system associated with non-cleared swaps and non-cleared security-based swaps held by covered swap entities. As a result, 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) counterparties 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.

These categories reflect the Agencies' preliminary belief that distinctions can be made between types of derivatives counterparties that are useful in distinguishing the risks posed by each type.

See proposed rule §§ __.2(b), (g), (h), (i), (n), (r) and (y) for the various constituent definitions that identify these four types of swap counterparties.

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.

This approach, which emphasizes the collection rather than the posting of margin, is based primarily on the Agencies' preliminary view that imposing requirements with respect to the minimum amount of margin to be collected (but not posted) is a critical aspect of offsetting the greater risk to the covered swap entity and the financial system arising from the covered swap entity's holdings of swaps and security-based swaps that are not cleared and helps ensure the safety and soundness of the covered swap entity. The proposed rule's approach would also assure that swap entities transacting with one another will effectively be collecting and posting margin with respect to those transactions as a result of the margin collection requirements imposed on each.

Section __.11 of the proposed rule adopted by FHFA and FCA (but not the other Agencies) requires that their regulated entities collect initial and variation margin from swap entities, as described in section III.K of this notice.

With respect to initial margin, the proposed rule permits a covered swap entity to select from two alternatives to calculate its initial margin requirements. A covered swap entity may calculate its initial margin requirements using a standardized “lookup” table that

specifies the minimum initial margin that must be collected, expressed as a percentage of the notional amount of the swap or security-based swap. These percentages depend on the broad asset class of the swap or security-based swap.

Alternatively, a covered swap entity may calculate its minimum initial margin requirements using an internal margin model that meets certain criteria and that has been approved by the relevant prudential regulator.

See

proposed rule, Appendix A.

See

proposed rule §§ __.2(

), __.3(a), __.8.

A covered swap entity adopting the first alternative generally must collect at least the amount of initial margin required under the standardized look-up table, regardless of the relative risk of its counterparty. A covered swap entity adopting the second alternative generally must collect at least the amount of initial margin required under its initial margin model. Both alternatives permit a covered swap entity to adopt a threshold amount below which it need not collect initial margin from certain types of counterparties.

Under the proposed rule, the maximum threshold amount permitted varies based on the relative risk posed by the counterparty, as determined by counterparty type.

See

proposed rule §§ __.2(m), __.3(a)(2).

With respect to variation margin, the proposed rule generally requires a covered swap entity to collect variation margin periodically in an amount that is at least equal to the increase in the value of the swap to the covered swap entity.

As with initial margin, a covered swap entity may adopt a threshold amount below which it need not collect variation margin from certain types of lower-risk counterparties.

Consistent with the approach taken to initial margin, the maximum threshold amount permitted for variation margin varies based on the relative risk of the counterparty, as determined by counterparty type. In addition, the frequency with which a covered swap entity must periodically recalculate and collect variation margin under the proposed rule also varies based on the relative risk of the counterparty, as determined by counterparty type, and generally decreases as the relative risk of the counterparty type decreases.

See

proposed rule §§ __.2(z), __.4(a).

See

proposed rule §§ __.2(bb), __.4(a)(2).

See

proposed rule § __.4(b).

The proposed rule's margin provisions establish only

minimum

requirements with respect to initial margin and variation that must be collected. Nothing in the proposed rule is intended to prevent or discourage a covered swap entity from collecting margin in amounts greater than is required under the proposed rule.

The proposed rule also specifies the types of collateral that are eligible to be collected to satisfy both the initial and variation margin requirements. Eligible collateral is generally limited to (i) immediately available cash funds and (ii) certain high-quality, highly-liquid U.S. government and agency obligations and, in the case of initial margin only, certain government-sponsored enterprise obligations, subject to specified minimum “haircuts” for purposes of determining their value for margin purposes.

See

proposed rule § __.6.

Separate from the proposed rule's requirements with respect to the collection of initial and variation margin, 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 Agencies have proposed a requirement that segregation of initial margin be mandatory, not optional, for swap transactions by a covered swap entity with another swap entity in order to (i) offset the greater risk to the covered swap entity and the financial system arising from the use of swaps and security-based swaps that are not cleared and (ii) protect the safety and soundness of the covered swap entity.

See

proposed rule § __.7. The Agencies note that sections 724 and 763 of Dodd-Frank Act require a swap entity to offer its swap and security-based swap counterparties the option of requiring segregation of initial margin they post to the swap entity.

B. Capital Requirements

Sections 731 and 764 of the Dodd-Frank Act also require the Agencies to issue, in addition to margin rules, joint rules on capital for covered swap entities for which they are the prudential regulator.

The Board, FDIC, and OCC (collectively, the banking agencies) have had risk-based capital rules in place for banks to address over-the-counter derivatives since 1989 when the banking agencies implemented their risk-based capital adequacy standards (general banking risk-based capital rules)

based on the first Basel Accord.

The general banking risk-based capital rules have been amended and supplemented over time to take into account developments in the derivatives market. These supplements include the addition of the market risk amendment to the first Basel Accord which requires banks and bank holding companies meeting certain thresholds to calculate their capital requirements for trading positions through models approved by their primary Federal supervisor.

In addition, certain large, complex banks and bank holding companies are subject to the banking agencies' advanced risk-based capital standards (advanced approaches rules), based on the advanced approaches of the Basel II Accord.

7 U.S.C. 6s(e)(2); 15 U.S.C. 78

-8(e)(2).

See

54 FR 4186 (January 27, 1989). The general banking risk-based capital rules are codified at 12 CFR part 3, Appendix A (OCC); 12 CFR parts 208 and 225, Appendix A (Board); and 12 CFR part 325, Appendix A (FDIC).

The Basel Committee on Banking Supervision (BCBS) developed the first international banking capital framework in 1988, entitled

International Convergence of Capital Measurement and Capital Standards.

61 FR 47358 (September 6, 1996). The banking agencies' market risk capital rules are at 12 CFR part 3, Appendix B (OCC); 12 CFR part 208, Appendix E and 12 CFR part 225, Appendix E (Board); and 12 CFR part 325, Appendix C (FDIC). The rules apply to banks and bank holding companies with trading activity (on a worldwide consolidated basis) that equals 10 percent or more of the institution's total assets, or $1 billion or more.

See

BCBS,

International Convergence of Capital Measurement and Capital Standards: A Revised Framework

(2006). The banking agencies implemented the advanced approaches of the Basel II Accord in 2007.

See

72 FR 69288 (December 7, 2010). The advanced approaches rules are codified at 12 CFR part 3, Appendix C (OCC); 12 CFR part 208, Appendix F and 12 CFR part 225, Appendix G (Board); and 12 CFR part 325, Appendix D (FDIC).

FHFA's predecessor agencies used a similar methodology to frame the risk-based capital rules applicable to those entities now regulated by FHFA. The FCA's risk-based capital regulations for Farm Credit System institutions, except for the Federal Agricultural Mortgage Corporation (Farmer Mac), have been in place since 1988 and were updated in 2005.

The FCA's risk-based capital regulations for Farmer Mac have been in place since 2001 and were updated in 2006.

See

53 FR 40.033 (Oct. 13, 1988); 70 FR 35.336 (June 17, 2005); 12 CFR part 615 subpart H.

See

66 FR 19,048 (April 12, 2001); 71 FR 77,247 (Dec. 26, 2006); 12 CFR part 652.

The Basel Committee on Banking Supervision has recently revised and enhanced its capital framework for internationally active banks,

and the banking agencies expect to propose these changes in the United States in the near future through a separate notice of proposed rulemaking.

See

BCBS,

Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems

(2010),

available at http://www.bis.org/publ.bcbs189.htm.

As described in section III.J below, the proposed rule requires a covered swap entity to comply with regulatory capital

rules already made applicable to that covered swap entity as part of its prudential regulatory regime. As discussed further below, given that these existing regulatory capital rules already specifically take into account and address the unique risks arising from derivatives transactions and activities, the Agencies are proposing to rely on these existing rules, subject to the future notice of proposed rulemaking described above, as appropriate and sufficient to offset the greater risk to the covered swap entity and the financial system arising from the use of swaps and security-based swaps that are not cleared and to protect the safety and soundness of the covered swap entity.

For the duration of the conservatorships of Fannie Mae and Freddie Mac (together, the Enterprises), FHFA has directed that their existing regulatory capital requirements would not be binding. However, FHFA continues to closely monitor the Enterprises' activities. Such monitoring, coupled with the unique financial support available to the Enterprises from the United States Treasury and the likelihood that FHFA will promulgate new risk-based capital rules in due course to apply to the Enterprises (or their successors) once the conservatorships have ended, lead to FHFA's preliminary view that the reference to existing capital rules is sufficient to address the risks discussed in the text above as to the Enterprises.

III. Section-by-Section Summary of Proposed Rule

A. Section __.1: Authority, Purpose and Scope

Section __.1 of the proposed rule specifies the scope of swap and security-based swap transactions to which the margin requirements apply. It provides that the margin requirements apply to all non-cleared swaps and security-based swaps into which a covered swap entity enters, regardless of the type of transaction or the nature of the counterparty. It also provides that the margin requirements apply only to swap and security-based swap transactions that are entered into on or after the date on which the proposed rule becomes effective.

1. Treatment of Pre-Effective Date Derivatives

The Agencies note that it is possible that a covered swap entity may enter into swap or security-based swap transactions on or after the proposed rule's effective date pursuant to the same master netting agreement with a counterparty that governs existing swaps or security-based swaps entered into prior to the effective date. As discussed below, the proposed rules permit a covered swap entity to (i) calculate initial margin requirements for swaps and security-based swaps under a qualifying master netting agreement with the counterparty on a portfolio basis in certain circumstances, if it is using an initial margin model to do so, and (ii) calculate variation margin requirements under the proposed rule on an aggregate, net basis under a qualifying master netting agreement with the counterparty. Applying the new margin rules in such a way would, in some cases, have the effect of applying the margin rules retroactively to pre-effective-date swaps under the master agreement. Accordingly, in the case of initial margin, a covered swap entity using an initial margin model would be permitted, at its option, to calculate the initial margin requirements on a portfolio basis but include only post-effective-date derivatives in the relevant portfolio.

With respect to variation margin, the Agencies expect that the covered swap entity will comply with the margin requirements with respect to all swaps and security-based swaps governed by a master agreement, regardless of the date on which they were entered into, consistent with current industry practice. The Agencies request comment on (i) what, if any, practical difficulties might be raised by the proposed approach to application of the margin requirements under master agreements governing both pre- and post-effective-date swaps and security-based swaps and (ii) whether there are alternative approaches that might better address the issues raised by such master agreements.

See

proposed rule § __.8(b). The covered swap entity would

not

be permitted to selectively incorporate only certain pre-effective-date derivatives.

2. Treatment of Derivatives With Commercial End User Counterparties

Following passage of the Dodd-Frank Act, various observers expressed concerns regarding whether sections 731 and 764 of the Dodd-Frank Act authorize or require the CFTC, SEC, and Agencies to establish margin requirements with respect to transactions between a covered swap entity and a “commercial end user” (

i.e.,

a nonfinancial counterparty that engages in derivatives activities to hedge commercial risk),

and have argued that swaps and security-based swap transactions with these types of counterparties should be excluded from the scope of margin requirements imposed under sections 731 and 764 because commercial firms engaged in hedging activities pose a reduced risk to their counterparties and the stability of the U.S. financial system. In addition, statements in the legislative history of sections 731 and 764 suggest that Congress did not intend, in enacting these sections, to impose margin requirements on nonfinancial end users engaged in hedging activities, even in cases where they entered into swaps or security-based swaps with swap entities.

Although the term “commercial end user” is not defined in the Dodd-Frank Act, it is generally understood to mean a company that is eligible for the exception to the mandatory clearing requirement for swaps and security-based swaps under section 2(h)(7) of the Commodity Exchange Act and section 3C(g) of the Securities Exchange Act, respectively. This exception is generally available to a person that (i) is not a financial entity, (ii) is using the swap to hedge or mitigate commercial risk, and (iii) has notified the CFTC or SEC how it generally meets its financial obligations with respect to non-cleared swaps or security-based swaps, respectively.

See

7 U.S.C. 2(h)(7) and 15 U.S.C. 78c-3(g).

See, e.g.,

156 Cong. Rec. S5904 (daily ed. July 15, 2010) (statement of Sen. Lincoln).

In formulating the proposed rule, the Agencies have carefully considered these concerns and statements. The plain language of sections 731 and 764 provides that the Agencies adopt rules for covered swap entities imposing margin requirements on

all non-cleared swaps.

Those sections do not, by their terms, exclude a swap with a counterparty that is a commercial end user.

Importantly, those sections also provide that the Agencies adopt margin requirements that (i) help ensure the safety and soundness of the covered swap entity and (ii) are appropriate for the risk associated with the non-cleared swaps and non-cleared security-based swaps it holds as a swap entity. Thus, the statute requires the Agencies to take a risk-based approach to establishing margin requirements.

The proposed rule follows this statutory framework and proposes a risk-based approach to imposing margin requirements in which nonfinancial end users are categorized as lower-risk counterparties than financial end users. In particular, the proposed rule permits covered swap entities to adopt, where appropriate, initial and variation margin thresholds below which a covered swap entity is not required to collect initial and/or variation margin from counterparties that are end users because of the lesser risk posed by these types of counterparties to covered swap entities and financial stability with respect to exposures below these thresholds. The Agencies note that this threshold-based approach is consistent with current market practices with respect to nonfinancial end users, in which derivatives dealers view the

question of whether and to what extent to require margin from their counterparties as a credit decision.

In the case of a nonfinancial end user with a strong credit profile, under current market practices a derivatives dealer would not require margin—in essence, it would extend unsecured credit to the end user with respect to the underlying exposure. For counterparties with a weak credit profile, a derivatives dealer would likely make a different credit decision and require the counterparty to post margin.

Under the proposed rule, a covered swap entity would not be required to collect initial or variation margin from a nonfinancial end user counterparty as long as the covered swap entity's exposures to the nonfinancial end user were below the credit exposure limits that the covered swap entity has established under appropriate credit processes and standards. The Agencies preliminarily believe that this approach is consistent with the statutory requirement that the margin requirements be risk-based, and is appropriate in light of the minimal risks that nonfinancial end users pose to the safety and soundness of covered swap entities and U.S. financial stability, particularly in cases of relatively small margin exposures.

To the extent that a covered swap entity has adopted an initial margin threshold amount or a variation margin threshold amount for a nonfinancial end user counterparty but the cumulative required initial margin or variation margin, respectively, for transactions with that end user exceeds the initial margin threshold amount or variation margin threshold amount, respectively, the covered swap entity would be required to collect the excess amount. The Agencies preliminarily believe that this approach is appropriate for the greater risk posed by such counterparties where margin exposures are relatively large.

The Agencies request comment on the appropriateness of the proposed rule's approach to a covered swap entity's transactions with nonfinancial end users and whether there are alternative approaches that would better achieve the objective of sections 731 and 764 of the Dodd-Frank Act. In particular, the Agencies note that under other provisions of the Dodd-Frank Act, nonfinancial end users that engage in derivatives to hedge their commercial risks are exempt from the requirement that all designated swaps and security-based swaps be cleared by a derivatives clearing organization or clearing agency, respectively. A major consequence of clearing a swap or security-based swap is a requirement that each party to the transaction post initial margin and variation margin to the derivatives clearing organization or clearing agency, and the exemption from the clearing requirement permits a nonfinancial end user taking advantage of the exemption to avoid posting margin to such central CCPs. Although the Dodd-Frank Act does not contain an express exemption from the margin requirement of sections 731 and 764 of the Dodd-Frank Act that is similar to the exemption for commercial end users from the mandatory clearing requirements of sections 723 and 763 of the Dodd-Frank Act, the Agencies note that the proposed rule's approach to margin requirements for derivatives with nonfinancial end users could be viewed as lessening the effectiveness of the clearing requirement exemption for these nonfinancial end users as concerns margin.

In particular, the Agencies request comment on the following questions:

Question 1(a).

Does the nonfinancial end user exemption from the mandatory clearing requirement suggest or require that swaps and security-based swaps involving a nonfinancial end user should or must be exempt from initial margin and variation margin requirements for non-cleared swaps and security-based swaps? 1(b) If so, upon what statutory basis would such an exemption rely? 1(c) Should that determination vary based on whether a particular non-cleared swap or non-cleared security-based swap is subject to the mandatory clearing regime or not (

i.e.,

whether the nonfinancial end user is actually using the clearing exemption)?

Question 2.

Should counterparties that are small financial institutions using derivatives to hedge their risks be treated in the same manner as nonfinancial end users for purposes of the margin requirements?

3. Effective Date

Section __.1 of the proposed rule provides that the proposed rule shall be effective with respect to any swap or security-based swap to which a covered swap entity becomes a party on or after the date that is 180 days following publication of the final rule in the

Federal Register

. The Agencies request comment regarding the appropriateness of this 180-day period.

The Agencies expect that covered swap entities are likely to need to make a number of changes to their current derivatives business operations in order to achieve compliance with the proposed rules, including potential changes to internal risk management and other systems, trading documentation, collateral arrangements, and operational technology and infrastructure. In addition, the Agencies expect that covered swap entities that wish to calculate initial margin using an initial margin model will need sufficient time to develop such models and obtain regulatory approval for their use. The Agencies request comment on the following implementation questions:

Question 3(a).

What changes to internal risk management and other systems, trading documentation, collateral arrangements, operational technology and infrastructure or other aspects of a covered swap entity's derivatives operations will likely need to be made as part of the implementation of the proposed rule, and how much time will likely be required to make such changes? 3(b) Is the proposed rule's 180-day period sufficient?

Question 4(a).

How much time will covered swap entities that wish to calculate initial margin using an initial margin model need to develop such models? 4(b) Is the proposed rule's 180-day period sufficient?

B. Section __.2: Definitions

Section __.2 of the proposed rule provides definitions of the key terms used in the proposed rule. In particular, § __.2 (i) defines the four types of swap and security-based swap counterparties that form the basis of the proposed rule's risk-based approach to margin requirements and (ii) provides other key operative terms that are needed to calculate the amount of initial and variation margin required under other sections of the proposed rule.

1. Counterparty Definitions

The four types of counterparties defined in the proposed rule are (in order of highest to lowest risk): (i) Swap entities; (ii) high-risk financial end users; (iii) low-risk financial end users; and (iv) nonfinancial end users.

a. “Swap entities”

The proposed rule defines “swap entity” as any entity that is required to register as a swap dealer, major swap participant, security-based swap dealer or major security-based swap participant.

Non-cleared swaps transactions with counterparties that are themselves swap entities pose risk to the financial system because swap entities are large players in swap and security-based swap markets and therefore have the potential to generate systemic risk through their swap activities. Because of their interconnectedness and large presence in the market, the failure of a single

swap entity could cause severe stress throughout the financial system.

Accordingly, it is the preliminary view of the Agencies that all non-cleared swap transactions with swap entities should require margin.

See

proposed rule § __.2(y).

This is consistent with the Dodd-Frank Act's requirement that the Agencies set margin and capital requirements appropriate for the risk to the financial system associated with non-cleared swaps held as a swap dealer or major swap participant. 7 U.S.C. 6(e)(3)(A); 15 U.S.C. 78

-8(e)(3)(A).

b. “Financial end users” and “nonfinancial end users”

Non-cleared swap transactions with end users (

i.e.,

those counterparties that are not themselves swap entities) can also pose risks to covered swap entities. Among end users, financial end users are considered more risky than nonfinancial end users because the profitability and viability of financial end users is more tightly linked to the health of the financial system than nonfinancial end users. Because financial counterparties are more likely to default during a period of financial stress, they pose greater systemic risk and risk to the safety and soundness of the covered swap entity. Section __.2 of the proposed rule defines a financial end user as any counterparty, other than a swap entity, that is: (i) A commodity pool (as defined in section 1a(5) of the Commodity Exchange Act (7 U.S.C. 1a(5))); (ii) a private fund (as defined in section 202(a) of the Investment Advisors Act of 1940 (15 U.S.C. 80-b-2(a))); (iii) an employee benefit plan (as defined in paragraphs (3) and (32) of section 3 of the Employee Retirement Income and Security Act of 1974 (29 U.S.C. 1002)); (iv) a person predominantly engaged in activities that are in the business of banking, or in activities that are financial in nature, as defined in section 4(k) of the Bank Holding Company of 1956 (12 U.S.C. 1843(k));

(v) a person that would be a commodity pool or private fund if it were organized under the laws of the United States or any State thereof; and (vi) any other person that one of the Agencies may designate with respect to covered swap entities for which it is the prudential regulator.

Although the proposed rule does not define a person predominantly engaged in activities that are in the business of banking, or in activities that are financial in nature, as defined in section 4(k) of the Bank Holding Company of 1956 (12 U.S.C. 1843(k)), the Agencies note that the Board has recently issued a proposed rule for comment defining a similar term for purposes of Title I of the Dodd-Frank Act. See 76 FR 7,731 (Feb. 11, 2011) (proposed rule). The Agencies request comment on whether they should apply the same methodology as is adopted for purposes of Title I of the Dodd-Frank Act for purposes of this clause of the proposed rule's definition of a financial end user, or whether an alternative methodology is appropriate.

See

proposed rule § __.2(h). This definition of “financial end user” is based upon, and substantially similar to, the definition of a “financial entity” that is ineligible to use the end user exemption from the mandatory clearing requirements of sections 723 and 763 of the Dodd-Frank Act.

See

7 U.S.C. 2(h)(7); 15 U.S.C. 78c-3(g).

The proposed definition of a counterparty that is a financial end user also includes any government of any foreign country or any political subdivision, agency, or instrumentality thereof.

The Agencies note that these types of sovereign counterparties do not fit easily into the proposed rule's categories of financial and nonfinancial end users. In comparing the characteristics of sovereign counterparties with those of financial and nonfinancial end users, the Agencies preliminarily believe that the financial condition of a sovereign will tend to be closely linked with the financial condition of its domestic banking system, through common effects of the business cycle on both government finances and bank losses, as well as through the safety net that many sovereigns provide to banks. Such a tight link with the health of its domestic banking system, and by extension with the broader global financial system, makes a sovereign counterparty similar to a financial end user both in the nature of the systemic risk and the risk to the safety and soundness of the covered swap entity. As a result, the Agencies propose to treat sovereign counterparties as financial end users for purposes of the proposed rule's margin requirements.

See

proposed rule § __.2(h)(6).

The proposed rule defines a nonfinancial end user as any counterparty that is an end user but is not a financial end user.

c. “High-risk financial end user” and “low-risk financial end user”

A financial end user counterparty whose derivatives activities are relatively limited and pose little or no risk is classified as a low-risk financial end user; other end user counterparties are classified as high-risk financial end users. The likelihood of a financial end user counterparty's failure with respect to a covered swap entity during stressed market conditions increases with, among other things, the size and riskiness of its derivatives activity, and the potential impact to the covered swap entity's safety and soundness increases with the size of its non-cleared swaps exposure to the end user counterparty. Accordingly, the proposed rule is structured so that a covered swap entity would generally be required to reduce its counterparty exposure through more stringent margin collection requirements with respect to non-cleared derivatives with financial end user counterparties having greater and riskier derivatives activities.

Section __.2 of the proposed rule deems a financial end user counterparty to be a low-risk financial end user only if it meets

all

of the following three criteria:

• Its swaps or security-based swaps fall below a specified “significant swaps exposure” threshold;

• It predominantly uses swaps to hedge or mitigate the risks of its business activities, including balance sheet, interest rate, or other risk arising from the business of the counterparty; and

• It is subject to capital requirements established by a prudential regulator or state insurance regulator.

See

proposed rule § __.2(n).

With respect to the first criterion, the definition of “significant swaps exposure” under the proposed rule is very similar to the definition of “substantial counterparty exposure” proposed by the CFTC and SEC for purposes of establishing what level of swap and security-based swap counterparty exposure would require a person to register as a major swap participant or major security-based swap participant under the Commodity Exchange Act or the Securities Exchange Act, respectively, except that the threshold amounts are established at half the level that would require registration as a major swap participant or major security-based swap participant.

The proposed rule's definition is thus intended to capture persons that, while not having derivatives positions rising to the level requiring margin requirements and comprehensive regulation as a major swap participant, nonetheless have substantial activity in the market and are more likely to pose greater risk to covered swap entities with which they transact than persons with only minor activity in the market. The Agencies request comment on whether this definition of significant swaps exposure is appropriate, or whether an alternative threshold amount or definition would be more consistent with the purposes of sections 731 and 764 of the Dodd-Frank Act.

See

75 FR 80,174 (Dec. 10, 2010).

The second criterion of the proposed definition of a low-risk financial end user references the purpose for which the financial end user enters into swaps or security-based swaps. This criterion

generally mirrors the description of hedging-related swaps and security-based swaps that are excluded for purposes of determining whether a person maintains a substantial position in swaps or security-based swaps and therefore meets the definition of a major swap participant or major security-based swap participant under the Commodity Exchange Act and Securities Exchange Act, respectively.

This distinction reflects the fact that persons using derivatives predominantly to hedge or mitigate risks arising from their business, rather than to speculate for profit, are likely to pose less risk to the covered swap entity (

e.g.,

because losses on a hedging-related swap will usually be accompanied by offsetting gains on the related position that it hedges).

See

7 U.S.C. 1a(33)(A)(i)(I); 15 U.S.C. 78c(a)(67)(a)(ii)(I).

The third criterion of the proposed definition of low-risk financial end user references whether the financial end user is subject to regulatory capital requirements. This criterion also generally mirrors the description of certain financial companies that are excluded from one prong of the definition of a major swap participant or major security-based swap participant under the Commodity Exchange Act and the Securities Exchange Act, respectively.

This distinction reflects the fact that financial end users that are subject to regulatory capital requirements are likely to pose less risk as counterparties (

e.g.,

because the requirements ensure that minimum amounts of capital will be available to absorb any losses on their derivatives transactions).

See

7 U.S.C. 1a(33)(A)(iii)(I); 15 U.S.C. 78c(a)(67)(a)(ii)(III)(aa).

The Agencies request comment on whether the proposed rule's categorization of various types of counterparties by risk, and the key definitions used to implement this risk-based approach, are appropriate, or whether alternative approaches or definitions would better reflect the purposes of sections 731 and 764 of the Dodd-Frank Act.

Question 5.

Do the definitions adequately identify financial end user counterparties that are high-risk and low-risk?

Question 6(a).

Should nonfinancial end users also be separated into high-risk and low-risk categories for purposes of the margin requirements? 6(b) If so, on what basis (

e.g.,

in a manner similar to the classification of high-risk and low-risk financial end users)? 6(c) If so, how should the margin requirement apply differently to such high-risk and low-risk nonfinancial end users?

Question 7(a).

Is the classification of sovereign counterparties as financial end users appropriate in light of the risks posed by these counterparties? 7(b) If not, what other classification would be appropriate, and why?

Question 8(a).

Should sovereign counterparties receive their own distinct counterparty classification that is different from those classifications in the proposed rule? 8(b) If so, why? 8(c) How should the permitted uncollateralized exposures to a sovereign counterparty differ from those that are allowed for financial or nonfinancial end users?

Question 9.

Is it appropriate to distinguish between financial and non-financial counterparties for the purpose of this risk-based approach?

Question 10.

What other factors or tests should be used to determine the relative risk of an end user counterparty?

Question 11(a).

Does the proposed rule require greater clarity with respect to the treatment of U.S. Federal, state, or municipal government counterparties? 11(b) If so, how should such counterparties be treated?

Question 12.

Should a counterparty that is a bank holding company or nonbank financial firm subject to enhanced prudential standards under Section 165 of the Dodd-Frank Act be treated similarly to swap entity counterparties?

The Agencies also request comment on the other definitions included in the proposed rule, including those discussed in further detail below.

C. Section __.3: Initial Margin

Section __.3 of the proposed rules specifies the manner in which a covered swap entity must calculate the initial margin requirement applicable to its swaps and security-based swaps. These initial margin requirements apply only to the amount of initial margin that a covered swap entity is required to collect from its counterparties; they do not address whether, or in what amounts, a covered swap entity must

post

initial margin to a derivatives counterparty. Except as described below in the summary of § __.6 of the proposed rule, the posting of initial margin by a covered swap entity to a counterparty is generally left to the mutual agreement of the covered swap entity and its counterparty. In the case where a covered swap entity enters into a swap with a counterparty that itself is a swap entity, its counterparty is likely to be subject to a regulatory margin requirement under section 731 or section 764 requiring it to collect margin from its counterparties. Thus, both parties to a non-cleared swap between two swap entities will have to collect and post margin as required by the SEC, CFTC or their prudential regulator, as applicable.

Separately, in the case of institutions regulated by FHFA and FCA, the effect of § __.11 of the proposed rule, when combined with the margin requirements contained in other parts of the proposed rule, would also be to effectively require both parties to a non-cleared swap or non-cleared security-based swap between a swap entity and an institution regulated by FHFA or FCA to both collect and post initial margin.

1. Calculation Alternatives

The proposed rule permits a covered swap entity to select from two alternatives for calculating its initial margin requirements. In all cases, the initial margin amount required under the proposed rule is a

minimum

requirement; covered swap entities are not precluded from collecting additional initial margin (whether by contract or subsequent agreement with the counterparty) when they believe it is appropriate or preferable to do so.

Under the first alternative, a covered swap entity may calculate its initial margin requirements using a standardized “lookup” table that specifies the minimum initial margin that must be collected as a percentage of the swap or security-based swap notional amount, which percentage varies depending on the broad asset class of the swap or security-based swap.

If the covered swap entity has entered into more than one swap or security-based swap with a counterparty (

i.e.,

a portfolio of swaps), the aggregate minimum initial margin required on those swaps and security-based swaps would be determined by summing the minimum initial margin requirement for each individual swap.

See

proposed rule §§ __.2(k)(1), __.3(a). Although the Agencies intend to specify a particular percentage in the final rule, the proposed rule provides a potential range of percentages for comment.

In many cases, however, the use of a standardized table may not accurately reflect the risk of a portfolio of swaps or security-based swaps, because the swaps or security-based swaps themselves vary in ways not reflected by the standardized table or because no reduction in required initial margin to reflect offsetting exposures, diversification, and other hedging benefits is permitted, as discussed below. For this reason, the proposed rule includes a second alternative.

Under the second alternative, a covered swap entity may calculate its minimum initial margin requirements

using an internal margin model that meets certain criteria and has been approved by the relevant prudential regulator.

Specifically, the covered swap entity must collect at least the amount of initial margin that is required under its internal model calculations (subject to any applicable initial margin threshold amount, as described below).

See

proposed rule §§ __.2(k)(2), __.3(a).

The Agencies request comment on whether the use of internal models or Appendix A is appropriate for the calculation of initial margin requirements. In particular, the Agencies request comment on the following questions:

Question 13.

As an alternative to Appendix A, should the rule allow an alternative calculation method that would link the margin on a non-cleared swap or non-cleared security-based swap to the margin required by a derivatives clearing organization for a cleared swap or cleared security-based swap whose terms and conditions closely resemble the terms and conditions of the non-cleared swap or non-cleared security-based swap?

Question 14.

Would there be enough similarity between cleared and non-cleared swaps or security-based swaps to make this approach workable?

Question 15.

With respect to either alternative for calculating initial margin requirements, should swap or security-based swap positions that pose no counterparty risk to the covered swap entity, such as a sold call option with the full premium paid at inception of the trade, be excluded from the initial margin calculation?

The Agencies also request comment on whether offsetting exposures, diversification, and other hedging benefits of multiple derivatives transactions can or should be more accurately represented in Appendix A's standardized table. The Agencies note that although the use of an initial margin model will allow for significant recognition of offsetting exposures, diversification, and other hedging benefits of swap and security-based swap positions that are conducted under a qualifying master netting agreement, Appendix A's standardized table is based upon gross notional amounts and recognizes no offsetting exposures, diversification, or other hedging benefits. In particular, the gross notional amount may not accurately reflect the size or riskiness of the actual position in many circumstances. For example, with respect to a swap portfolio containing (i) a one year pay fixed and receive floating interest rate swap with a notional value of $10 million and (ii) a two year pay floating and receive fixed interest rate swap with a notional value of $10 million, an initial margin model would recognize that much of the risk of the one year swap is offset by the risk of the two year swap—changes in the level of interest rates that increase the value of the one year swap will simultaneously decrease the value of the two year swap. Under Appendix A, however, the gross notional interest rate swap position would be $20 million and the initial margin on the portfolio would be twice the initial margin of either $10 million swap even though the trades are, in fact, risk reducing.

The Agencies are concerned that the use of gross notional amounts alone in determining initial margin may not adequately recognize offsetting exposures, diversification, and other hedging benefits that are well understood as in the above example. This lack of recognition might lead to large disparities between a firm that uses a model to set initial margin and a firm that uses the standardized initial margin requirements. These disparities may give rise to significant competitive inequities between firms that do and do not adopt an approved initial margin model.

The Agencies request comment on possible changes to the standardized method of calculating initial margin requirements to better reflect the effect of offsets and hedging when swaps and security-based swaps are conducted under a qualifying master netting agreement. In particular, the Agencies seek comment on the following questions:

Question 16.

Would calculating the standardized initial margin for a particular risk category by separately calculating the initial margin required on the long positions and short positions and then using only the higher of these two amounts adequately account for offsetting exposures, diversification, and other hedging benefits within a standardized initial margin framework?

Question 17.

Would the method described above systematically overestimate or underestimate offsetting exposures, diversification, and other hedging benefits? Is this method prone to manipulation or other gaming concerns?

Question 18.

Should the Agencies consider some degree of offset across risk categories? If so how should these offsets be determined?

Question 19.

Would adjusting the gross notional amount of swap positions in a particular risk category (

e.g.,

commodity, credit, equity, or foreign exchange/interest rate) by a net-to-gross ratio or a netting factor in a manner that is similar to the method used for adjusting potential future exposure calculations for purposes of the Federal banking agencies' risk-based capital rules adequately capture offsetting exposures, diversification, and other hedging benefits?

Question 20.

Would adjustment of gross notional amounts with a net-to-gross ratio or a netting factor systematically overestimate or underestimate offsetting exposures, diversification, and other hedging benefits?

Question 21.

Are there additional methods that could be used in conjunction with a standardized lookup initial margin table that adequately recognize offsetting exposures, diversification, and other hedging benefits?

Question 22(a).

Are such methods transparent and implementable? 22(b) Can they be generalized across multiple risk categories and swap types?

As an alternative, the Agencies request comment on whether Appendix A should be revised to adopt a method that more fully reflects the offsetting of positions at default. For example, such a method might rely on a calculation of an adjusted gross notional amount that would reduce the amount of initial margin required when a counterparty has many offsetting trades under a qualifying master netting agreement. To calculate the adjusted gross notional amount for an asset class, one would first calculate the net notional to gross notional ratio. This netting factor would be the absolute value of the difference between the long notional contracts and the short notional contracts divided by the total gross notional amount of the contracts. This value would then be used as a type of correlation factor among the contracts. The adjusted gross notional amount would then be calculated as follows, where

is the gross notional value of trades in an asset class and “

” is the netting factor:

EP11MY11.016

The adjusted gross notional amount, rather than the gross notional amount, would then be used to calculate initial margin using Appendix A.

When the netting factor is zero, initial margin would still be required to be collected, and when the net to gross ratio is one (all positions are one way) the netting factor is also one so that the adjusted gross notional is equal to the gross notional. This method would allow offsetting transactions that reduce risk to reduce initial margin, but would not allow the offset to ever be perfect, so that initial margin would always be required to be collected. The adjusted gross notional method would be applied to the initial margin calculation by using gross notional amounts within an asset class. The Agencies seek comment on these methods, as well as alternative methods for calculating initial margin requirements under Appendix A and potential ways in which Appendix A might better capture the offsetting exposures, diversification, and other hedging benefits.

2. Initial Margin Thresholds

As part of the proposed rule's initial margin requirements, a covered swap entity using either alternative is also permitted to establish, for counterparties that are low-risk financial end users or nonfinancial end users, a credit exposure limit below which it need not collect initial margin.

A covered swap entity is not permitted to establish an initial margin threshold amount for a counterparty that is either (i) a covered swap entity itself or (ii) a high-risk financial end user.

See

proposed rule §§ __.2(m), __.3(a). A covered swap entity that has established an initial margin threshold amount for a counterparty need only collect initial margin if the required amount exceeds the initial margin threshold amount, and in such cases is only required to collect the excess amount.

See

proposed rule § __.2(m)(1).

This credit exposure limit is defined in the proposed rule as the initial margin threshold amount.

The maximum initial margin threshold amount that a covered swap entity may establish varies based on the relative risk of the counterparty, as determined by counterparty type (

e.g.,

financial versus nonfinancial end user). With respect to a counterparty that is a low-risk financial end user, the proposed rule limits the maximum initial margin threshold amount that a covered swap entity may establish for a particular counterparty to the lower of (i) a range of $15 to $45 million or (ii) a range of 0.1 to 0.3 percent of the covered swap entity's tier 1 capital.

Although the Agencies have proposed a range of specific maximum initial margin threshold amounts for a counterparty that is a low-risk financial end user, the Agencies' preliminary view is that the midpoint of each range would in each case be an appropriate amount. With respect to counterparties that are nonfinancial end users, the proposed rule does not place a specific limit on the maximum initial margin threshold amount that a covered swap entity may establish.

See

proposed rule § __.2(m).

Although the Agencies intend to specify particular amounts in the final rule, the proposed rule provides a potential range of numbers for comment. Since tier 1 capital is not a concept that is applicable to covered swap entities for which FHFA or the FCA is the prudential regulator, the thresholds as applied to such entities instead reference (i) in the case of covered swap entities for which FHFA is the prudential regulator, the term “total capital,” as separately defined within the proposed regulatory text of FHFA's proposed rule, and (ii) in the case of covered swap entities for which the FCA is the prudential regulator, the term “applicable core surplus or core capital (or successor high quality capital requirement),” as separately defined within the proposed regulatory text of the FCA's proposed rule.

The proposed rule allows uncollateralized exposures below the initial margin threshold amount for certain counterparties because taking uncollateralized credit exposure to counterparties is a long established business practice at the firms regulated by the Agencies. When well managed, taking on credit exposure does not automatically lead to unacceptable levels of systemic risk. Credit exposure can arise from a number of activities that regulated firms are permitted to engage in with a counterparty—making a loan, opening a committed line of credit, providing payments processing or transaction services, or engaging in swaps transactions. Although the proposal permits such credit exposure in certain circumstances, the proposed rule seeks to ensure that initial margin is collected in amounts that are appropriate to the risks posed by counterparties that are low-risk financial end users or nonfinancial end users.

The proposed rule requires that any credit exposure limit that a covered swap entity establishes as an initial threshold amount for a counterparty (i) appropriately take into account and address the credit risk posed by the counterparty and the risks of such swaps and security-based swaps and (ii) be reviewed, monitored, and approved in accordance with the swap entity's credit processes. Threshold amounts that are established in accordance with these standards are unlikely to generate meaningful risk to the safety and soundness of the covered swap entity and do not pose systemic risk.

In addition, in the case of counterparties that are low-risk financial end users, which the Agencies preliminarily believe pose greater risk than nonfinancial end users, the proposed rule imposes additional restrictions by limiting the maximum initial margin threshold amount that a covered swap entity may establish.

The Agencies also note that the categories of counterparties for which the proposed rule permits a covered swap entity to establish an initial margin threshold amount are roughly aligned with the Dodd-Frank Act exemption of non-financial end users from the Dodd-Frank Act mandatory clearing requirement.

See

7 U.S.C. 2(h)(7); 15 U.S.C. 78c-3(g).

The Agencies expect that covered swap entities will establish initial margin threshold amounts only when they have meaningfully evaluated the creditworthiness of the counterparty and have made a credit and risk management decision to expose themselves to the unsecured credit of the counterparty pursuant to their generally applicable credit approval processes. The Agencies also expect that covered swap entities will monitor initial margin threshold amounts and adjust them downward to reflect any deterioration in the credit quality of the counterparty or other increase in the risks the counterparties' swaps and security-based swaps pose. Under the proposed rule, even where an initial margin threshold amount is established, the covered swap entity must still calculate the initial margin amount for the counterparty pursuant to § __.3 of the proposed rule and, to the extent that the initial margin amount exceeds the initial margin threshold amount that has been established, collect initial margin equal to the excess amount.

For those counterparties that pose the greatest threat to systemic stability by virtue of their interconnectedness and the size of their uncollateralized and potential outward exposures—namely, other swap entities and high-risk financial end users—the proposed rule

does not permit any exposure to remain uncollateralized; the threshold amount is effectively zero. It is the preliminary view of the Agencies that the potential systemic risk from other swap entities should lead to an amount of initial margin being actually collected. Margin should also be collected for all non-cleared swaps and non-cleared security-based swaps with high-risk financial end users because, as previously discussed, they are more likely to default during periods of financial stress and thus pose greater systemic risk and risk to the safety and soundness of the covered swap entity.

The Agencies request comment regarding whether it is appropriate to permit covered swap entities to establish initial margin threshold amounts for certain counterparties in the manner proposed. In particular, the Agencies request comment on the following questions:

Question 23(a).

Does the maximum initial margin threshold amount proposed for counterparties that are low-risk financial end users strike an appropriate balance between traditional credit extension practices and the potential for systemic risk or risk to the safety and soundness of a covered swap entity? 23(b) Should threshold amounts for nonfinancial end users be subject to a similar limit? 23(c) If so, at what maximum amount or amounts? 23(d) Do the derivatives activities and exposures of nonfinancial end users have the potential to create systemic risk, either individually or in aggregate?

Question 24.

Is it appropriate for the threshold amounts to be capped at a fixed dollar amount?

Question 25.

Should the rule also place a limit on the threshold amounts that a covered swap entity establishes for all counterparties in the aggregate?

Question 26(a).

Is it appropriate for the threshold amounts to be determined by reference to the tier 1 or other measure of capital of a covered swap entity? 26(b) What other measures might be used to determine appropriate threshold amounts?

Question 27(a).

Should the various threshold amounts be subject to an automatic adjustment for inflation on a periodic basis? 27(b) If so, what type of adjustment would be appropriate?

3. Minimum Transfer Amount

In addition, the proposed rule provides for a minimum transfer amount for the collection of margin by covered swap entities, under which a covered swap entity need not collect initial margin from any individual counterparty otherwise required under the proposed rule until the required cumulative amount is $100,000 or more.

See

proposed rule § __.3(c). The minimum transfer amount only affects the timing of margin collection; it does not change the amount of margin that must be collected once the $100,000 threshold is crossed. For example, if the initial margin requirement were to increase from $50,000 to $110,000, the covered swap entity would be required to collect the entire $110,000 (subject to application of any applicable initial margin threshold amount).

4. Alternative Approach to Initial Margin Requirements

The Agencies also request comment on several alternative approaches to implementation of the initial margin requirements.

First, the Agencies request comment on whether the proposed rule should be augmented by (i) imposing a separate, additional requirement that a covered swap entity

post

initial margin to any counterparty that is an end user, including both financial and nonfinancial end users and (ii) requiring the covered swap entity to ensure that any such initial margin posted is segregated at a third-party custodian. In particular, the Agencies request comment on the following questions:

Question 28.

Would requiring a covered swap entity to post initial margin to end user counterparties reduce systemic risk (

e.g.,

by reducing leverage in the financial system or reducing systemic vulnerability to the failure of a covered swap entity)?

Question 29.

Are there alternatives that address those risks more efficiently or with greater transparency?

Question 30.

Would requiring a covered swap entity to post initial margin to end user counterparties raise any concerns with respect to the safety and soundness of the covered swap entity, taking into consideration the requirement that initial margin be segregated and held with a third party custodian?

Question 31.

Would requiring a covered swap entity to post initial margin to end user counterparties remove one or more incentives for that covered swap entity to choose, where possible, to structure a transaction so that it need not be cleared through a CCP in order to avoid pledging initial margin?

Question 32.

Would this approach be consistent with the statutory factors the Agencies are directed to take into account under sections 731 and 764 of the Dodd-Frank Act?

Second, the Agencies request comment on whether the proposed rule should be augmented by (i) imposing a separate, additional requirement that a covered swap entity

post

initial margin to any end user counterparty that is a systemically significant financial institution under Title I of Dodd-Frank Act, and (ii) requiring the covered swap entity to ensure that any such initial margin posted is segregated at a third-party custodian. In particular, the Agencies request comment on the following questions:

Question 33.

Would requiring a covered swap entity to post initial margin to systemically-significant end user counterparties reduce systemic risk (

e.g.,

by reducing leverage in the financial system or reducing systemic vulnerability to the failure of a covered swap entity)?

Question 34.

Are there alternatives that address those risks more efficiently or with greater transparency?

Question 35.

Would requiring a covered swap entity to post initial margin to systemically-significant end user counterparties raise any concerns with respect to the safety and soundness of the covered swap entity, taking into consideration the requirement that initial margin be segregated and held with a third party custodian?

Question 36.

Would requiring a covered swap entity to post initial margin to systemically-significant end user counterparties remove one or more incentives for that covered swap entity to choose, where possible, to structure a transaction so that it need not be cleared through a CCP in order to avoid pledging initial margin?

Question 37.

Would this approach be consistent with the statutory factors the Agencies are directed to take into account under sections 731 and 764 of the Dodd-Frank Act?

Third, the Agencies request comment on whether the proposed rule should establish a distinct category of covered swap entities that, because of the relatively small size of the derivatives activities and the lesser risk they pose to U.S. financial stability, would be subject to less stringent initial margin requirement. In particular, such an approach would (i) permit such “low-risk” covered swap entities to establish larger initial or additional margin threshold amounts (

e.g.,

for counterparties that are swap entities) and (ii) not require such “low-risk” covered swap entities to comply with the segregation requirements of § __.7 of the proposed rule. Such low-risk covered swap entities could be defined by identifying a particular threshold amount of derivatives activities below which one would be considered a low-risk covered swap entity. For example, under this approach, a low-risk covered swap entity might be defined as a covered swap entity whose total

positions in swaps and security-based swaps are below the applicable thresholds established by the SEC and CFTC for determining whether a firm is a major swap participant or major security-based swap participant, respectively. In particular, the Agencies request comment on the following questions:

Question 38.

Would establishing a category of low-risk covered swap entity and subjecting that category to less stringent initial margin requirements enhance or reduce systemic risk?

Question 39.

Would establishing a category of low-risk covered swap entity and subjecting that category to less stringent initial margin requirements raise any concerns with respect to the safety and soundness of such an entity?

Question 40.

If the Agencies adopted such an approach, how should a low-risk covered swap entity be defined? Should the definition reference the thresholds established by the SEC and CFTC for determining whether a firm is a major swap participant or major security-based swap participant, or some variant of those thresholds?

Question 41.

What less stringent initial margin requirements should apply to such low-risk covered swap entities? What, if any, segregation requirement should apply to such low-risk covered swap entities?

Question 42.

Would such an approach encourage covered swap entities to separate their derivatives activities into multiple entities so as to avail themselves of the exemption?

Question 43.

Would this approach be consistent with the statutory factors the Agencies are directed to take into account under sections 731 and 764 of the Dodd-Frank Act?

D. Section __.4: Variation Margin

Section __.4 of the proposed rules specifies the manner in which a covered swap entity must calculate the variation margin requirement applicable to swaps and security-based swaps it enters into. As with initial margin requirements, (i) these variation margin requirements apply only to

collection

of variation margin by covered swap entities from their counterparties, and not to the

posting

of variation margin to their counterparties,

and (ii) establish only a

minimum

amount of variation margin that must be collected, leaving covered swap entities free to collect larger amounts if they so choose. Consistent with current practice, covered swap entities and their counterparties would remain free to negotiate the extent to which a covered swap entity may be required to post variation margin to a counterparty (other than a swap entity that is itself subject to margin requirements).

As described in section III.K of this notice, FHFA's and the FCA's proposed rules contain an additional provision that will have a different effect with respect to entities regulated by FHFA and the FCA.

The proposed rule generally requires a covered swap entity to collect variation margin from its counterparties on a periodic basis.

The amount of variation margin that is required to be periodically collected must be equal to or greater than (i) the cumulative mark-to-market change in value to the covered swap entity of a swap or security-based swap, as measured from the date it is entered into,

less

(ii) the value of all variation margin previously collected but not returned by the covered swap entity with respect to such swap or security-based swap.

See

proposed rule § __.4(a).

The proposed rule defines this required amount as the “variation margin amount.”

See

proposed rule § __.2(bb). In the case of swap or security-based swap that is out-of-the-money or in-the-money to a covered swap entity at the time it enters into the transaction, that amount is also included within the definition of variation margin amount and subject to the variation margin requirements.

1. Variation Margin Thresholds and Minimum Transfer Amounts

Similar to the initial margin requirement under § __.3 of the proposed rule, § __.4 permits a covered swap entity to establish, for certain counterparties that are end users, a credit exposure limit that acts as a variation margin threshold below which it need not collect variation margin.

Although the variation margin threshold is separate from, and may be applied independently from, the initial margin threshold with respect to qualifying counterparties, the variation margin threshold amount that a covered swap entity may establish for counterparties that are low-risk financial end users is subject to the same specified maximum amount that governs initial margin threshold amounts for such counterparties. As with initial margin threshold amounts, a covered swap entity may not establish a variation margin threshold amount for counterparties that are swap entities or high-risk financial end users.

See

proposed rule §§ __.2(bb), __.4(a).

In addition, the proposed rule's variation margin requirements contain provisions similar to those governing initial margin with respect to minimum transfer amounts.

2. Aggregate Calculation of Variation Margin Requirements Under a Qualifying Master Netting Agreement

The proposed rule permits a covered swap entity to calculate variation margin requirements on an aggregate basis across all swap or security-based swap transactions with a counterparty that are executed under the same qualifying master netting agreement.

The proposed rule defines a qualifying master netting agreement as a legally enforceable agreement to offset positive and negative mark-to-market values of one or more swaps or security-based swaps that meet a number of specific criteria designed to ensure that these offset rights are fully enforceable, documented and monitored by the covered swap entity.

The Agencies request comment regarding whether permitting the aggregate calculation of variation margin requirements is appropriate and, if so, whether the proposed rule's definition of qualifying master netting agreement raises practical or implementation difficulties or is inconsistent with current market practices.

See

proposed rule § __.4(d).

See

proposed rule § __.2(t). The proposed rule's definition of qualifying master netting agreement generally mirrors the definition given to that term in the Federal banking agencies' risk-based capital rules applicable to derivatives positions held by insured depository institutions and bank holding companies.

See, e.g.,

12 CFR part 225, App. G.I.2.

3. Frequency of Variation Margin Calculation and Collection

The proposed rule also specifies the minimum frequency with which a covered swap entity must calculate and collect initial margin. Consistent with the approach of the proposed rule generally, the minimum frequency varies based on the systemic and safety and soundness risk of the counterparty type. Covered swap entities must calculate and collect variation margin from counterparties that are themselves swap entities or financial end users at least once per business day, and from counterparties that are nonfinancial end users at least once per week. The Agencies request comment on whether the proposed rule's approach to the frequency with which the variation margin requirements must be met is consistent with current market practices, and whether alternative approaches to imposing variation margin requirements would better reflect the purposes of section 731 and 764 of the Dodd-Frank Act.

4. Counterparty Refusal to Provide Required Variation Margin

Section __.4(e) of the proposed rule addresses potential circumstances in which a counterparty may refuse to provide required variation margin to a covered swap entity. Specifically, it provides that a covered swap entity shall not be deemed to have violated its regulatory obligation to collect required variation margin from a counterparty if the counterparty has refused or otherwise failed to provide the required variation margin to the covered swap entity and the covered swap entity has either (i) made the necessary efforts to attempt to collect the required variation margin, including the timely initiation and continued pursuit of formal dispute resolution mechanisms, or has otherwise demonstrated upon request to the satisfaction of the relevant Agency that it has made appropriate efforts to collect the required variation margin, or (ii) commenced termination of the swap or security-based based swap with the counterparty.

The Agencies note that, in each such case, the covered swap entity will have been required, under § __.5 of the proposed rule, to obtain the contractual right to collect such variation margin as is necessary to permit it to comply with the requirements of § __.4 of the proposed rule and set out valuation dispute resolution procedures.

See

proposed rule § __.4(e). The Agencies note that there is no similar reference to appropriate efforts in the proposed rule initial margin requirements; since initial margin is collected at the time a swap or security-based swap is entered into, a covered swap entity can and must collect any required initial margin as prerequisite to executing the transaction.

5. Alternative Approach to Variation Margin Requirements

The Agencies also request comment on several alternative approaches to implementation of the variation margin requirements.

First, the Agencies request comment on whether the proposed rule should be augmented by imposing a separate, additional requirement that a covered swap entity

post

variation margin to any counterparty that is an end user, including both financial and nonfinancial end users. In particular, the Agencies request comment on the following questions:

Question 44.

Would requiring a covered swap entity to post variation margin to end user counterparties reduce systemic risk (

e.g.,

by reducing leverage in the financial system or reducing systemic vulnerability to the failure of a covered swap entity)?

Question 45.

Are there alternatives that address those risks more efficiently or with greater regulatory transparency?

Question 46.

Would requiring a covered swap entity to post variation margin to end user counterparties raise any concerns with respect to the safety and soundness of the covered swap entity?

Question 47.

Would requiring a covered swap entity to post variation margin to end user counterparties remove one or more incentives for that covered swap entity to choose, where possible, to structure a transaction so that it need not be cleared through a CCP in order to avoid pledging variation margin?

Question 48.

Would this approach be consistent with the statutory factors the Agencies are directed to take into account under sections 731 and 764 of the Dodd-Frank Act?

Second, the Agencies request comment on whether the proposed rule should be augmented by imposing a separate, additional requirement that a covered swap entity

post

variation margin to any end user counterparty that is a systemically significant financial institution under Title I of Dodd-Frank Act. In particular, the Agencies request comment on the following questions:

Question 49.

Would requiring a covered swap entity to post variation margin to systemically-significant end user counterparties reduce systemic risk (

e.g.,

by reducing leverage in the financial system or reducing systemic vulnerability to the failure of a covered swap entity)?

Question 50.

Are there alternatives that address those risks more efficiently or with greater regulatory transparency?

Question 51.

Would requiring a covered swap entity to post variation margin to systemically-significant end user counterparties raise any concerns with respect to the safety and soundness of the covered swap entity?

Question 52.

Would requiring a covered swap entity to post variation margin to systemically-significant end user counterparties remove one or more incentives for that covered swap entity to choose, where possible, to structure a transaction so that it need not be cleared through a CCP in order to avoid pledging variation margin?

Question 53.

Would this approach be consistent with the statutory factors the Agencies are directed to take into account under sections 731 and 764 of the Dodd-Frank Act?

Third, the Agencies request comment on whether the proposed rule should establish a distinct category of swap entities that, because of the relatively small size of the derivatives activities and the lesser risk they pose to U.S. financial stability, would be subject to less stringent variation margin requirement. In particular, such an approach would permit such “low- risk” covered swap entities to establish larger variation margin threshold amounts. Such low-risk covered swap entities could be defined as described in section III.C.4 of this notice. In particular, the Agencies request comment on the following questions:

Question 54.

Would establishing a category of low-risk covered swap entity and subjecting such an entity to less stringent variation margin requirements enhance or reduce systemic risk?

Question 55.

Would establishing a category of low-risk covered swap entity and subjecting such an entity to less stringent variation margin requirements raise any concerns with respect to the safety and soundness of such an entity?

Question 56.

If the Agencies adopted such an approach, how should a low-risk covered swap entity be defined? What less stringent variation margin requirements should apply to such low risk covered swap entities?

Question 57.

Would such an approach encourage covered swap entities to separate their derivatives activities into multiple entities so as to avail themselves of the exemption?

Question 58.

Would this approach be consistent with the statutory factors the Agencies are directed to take into account under sections 731 and 764 of the Dodd-Frank Act?

E. Section __.5: Documentation of Margin Matters

The proposed rule requires a covered swap entity to execute trading documentation with each counterparty that includes credit support arrangements that grant the covered swap entity the contractual right to collect initial margin and variation margin in such amounts, in such form, and such circumstances as are required by the initial margin and variation margin requirements set forth in the proposed rule.

The trading documentation must also specify (i) the methods, procedures, rules, and inputs for determining the value of each swap or security-based swap for purposes of calculating variation margin requirements and (ii) the procedures by which any disputes concerning the valuation of swaps or security-based swaps, or the valuation of assets

collected or posted as initial margin or variation margin, may be resolved.

See

proposed rule § __.5.

See id.

F. Section __.6: Eligible Collateral

The proposed rule specifies the types of collateral that are eligible to be collected to satisfy either the initial margin or variation margin requirements. Under the proposed rule, eligible collateral is limited to: (i) Immediately available cash funds (denominated in either U.S. dollars or in the currency in which payment obligations under the swap are required to be settled); (ii) any obligation which is a direct obligation of, or fully guaranteed as to principal and interest by, the United States; (iii) with respect to initial margin only, any senior debt obligations of the Federal National Mortgage Association, the Federal Home Loan Mortgage Corporation, the Federal Home Loan Banks and Farmer Mac; and (iv) with respect to initial margin only, any obligation that is an “insured obligation,” as that term is defined in 12 U.S.C. 2277a(3), of the Farm Credit System banks.

Other than immediately-available cash funds, all types of eligible collateral are subject to discounts or minimum “haircuts” for purposes of determining their value for margin purposes, which haircuts are identified in Appendix B of the proposed rule.

Because the value of noncash collateral may vary, the proposed rule requires covered swap entities to monitor the value of noncash collateral previously collected to satisfy initial or variation margin requirements and, to the extent the value of such noncash collateral has decreased, to collect additional collateral with a sufficient value to ensure that all applicable initial and variation margin requirements remain satisfied.

The proposed rule also prohibits a covered swap entity from collecting, as required initial margin or variation margin, collateral that is an obligation of the counterparty pledging such collateral.

See

proposed rule § _6(a). An obligation will be considered to be fully guaranteed as to principal and interest by the United States if the guarantee commits the full faith and credit of the United States for the repayment of principal and interest on the obligation. “Insured obligations” of Farm Credit System banks are consolidated and System-wide obligations issued by Farm Credit System banks. These obligations are insured by the Farm Credit System Insurance Corporation out of funds in the Farm Credit Insurance Fund. Should the Farm Credit Insurance Fund ever be exhausted, Farm Credit System banks are jointly and severally liable for payment on insured obligations.

See

proposed rule § _6(b). With respect to these haircuts, although the Agencies intend to specify particular haircut amounts in the final rule, the proposed rule provides a potential range of haircuts for comment.

See

proposed rule § _6(d).

See

proposed rule § _6(c).

The proposed rule does

not

allow for the use of non-cash collateral, other than the limited types of highly-liquid, high-quality debt securities described above, to satisfy the margin requirements. The appropriateness of using non-cash collateral to fulfill margin requirements is complicated by procyclical considerations. During a period of financial stress, the value of non-cash collateral pledged as margin may also come under stress just as counterparties default and the non-cash collateral is required to offset the cost of replacing defaulted swap positions. In addition, given the infinite variety of potential types of noncash collateral, it is extremely difficult to establish accurate haircuts by regulation. Also, for nonfinancial end users, who are the most likely type of counterparty to wish to post noncash collateral, the proposed rules provide credit exposure thresholds, under which a covered swap entity may determine the extent to which available noncash collateral appropriately reduces the covered swap entity's credit risk, consistent with its credit underwriting expertise. Similarly, counterparties that wish to rely on other non-cash assets to meet margin requirements could pledge those assets with a bank or group of banks in a separate arrangement, such as a secured financing facility, and could draw cash from that arrangement to meet margin requirements.

The Agencies request comment on whether the proposed rule's list of eligible noncash collateral for initial margin and variation margin is appropriate in scope. In particular, the Agencies request comment on the following questions:

Question 59(a).

Should the types of eligible collateral listed be broadened to include other types of assets (

e.g.

securities backed by high-quality mortgages or issued with a third-party guarantee)? 59(b) If so, how might the systemic risk issue described above be effectively mitigated?

Question 60(a).

Should the types of eligible collateral listed be broadened to include immediately-available cash funds denominated in foreign currency, even where such currency is not the currency in which payment obligations under the swap are required to be settled? 60(b) If so, which currencies (

e.g.,

those accepted by a derivatives clearing organization as initial margin for a cleared swap)? 60(c) If so, what haircut, if any, should apply to such foreign currency?

Question 61.

What criteria and factors could be used to determine the set of acceptable non-cash collateral?

Question 62.

How could appropriate haircuts be determined for valuing these assets for margin purposes?

Question 63(a).

Should the types of eligible collateral listed be broadened to include foreign sovereign debt securities? 63(b) If so, which foreign sovereign debt securities (

e.g.,

those accepted by a derivatives clearing organization as initial margin for a cleared swap)? 63(c) If so, what haircut, if any, should apply?

Question 64(a).

Should fixed income securities issued by a well-known seasoned issuer that has a high credit standing, are unsubordinated, historically display low volatility, are traded in highly liquid markets, and have valuations that are readily calculated be added to the list of eligible collateral for initial margin? 64(b) If so, how should the concept of a “high credit standing” be defined in a way that does not reference credit ratings?

G. Section __.7: Segregation of Collateral

The proposed rule provides that each covered swap entity must require each derivative's counterparty that it faces that is a swap entity to segregate any funds or collateral that the covered swap entity has posted as initial margin for a non-cleared swap or non-cleared security-based swap transaction at an independent, third-party custodian.

This independent, third-party custodian must be prohibited by contract from (i) rehypothecating or otherwise transferring any initial margin it holds for the covered swap entity and (ii) reinvesting any initial margin held by the custodian in any asset that would not qualify as eligible collateral for initial margin under the proposed rule.

The custodian must also be located in a jurisdiction that applies the same insolvency regime to the custodian as would apply to the covered swap entity.

This segregation requirement applies only to initial margin, not variation margin, and does not apply to transactions with a counterparty that is an end user of any type.

See

proposed rule § _7(a).

See

proposed rule §§ _7(b), (c).

See

proposed rule § _7(d).

The proposed rule does not apply the segregation requirement to variation margin because variation margin is generally used to offset the current exposure arising from

actual

changes in the market value of the derivative position, rather than to secure potential exposure arising from

future

changes in the market value of the derivative position. Under section __.11 of FHFA's and the FCA's proposed rules, entities regulated by FHFA and the FCA that are end users would have to require that any initial margin and variation margin they post to swap entities be segregated.

The Agencies' preliminary view is that requiring covered swap entities to ensure segregation of initial margin is necessary to (i) offset the greater risk to the covered swap entity and the financial system arising from the use of swaps and security-based swaps that are not cleared and (ii) protect the safety and soundness of the covered swap entity. In developing this proposal, the Agencies have taken into account the fact that the failure of a covered swap entity could pose significant systemic risks to the financial system and losses borne by the financial system in such a failure could have significant consequences. The consequences could be magnified if the initial margin posted to the failing swap entity cannot be quickly recovered by the nondefaulting party during a period of financial stress when the liquidity value of the funds is high. Moreover, swap entities typically have roughly offsetting exposures with one another. As a result, it is to be expected that the amount of initial margin required to be posted by two swap entities will be similar. If swap entities exchange similar amounts of initial margin and these funds are available for general use and rehypothecation by the swap entities, then the net effect is as if little initial margin was exchanged. To the extent that initial margin requirements are intended to constrain risk-taking, a lack of segregation will weaken their effect.

For example, if dealer A and dealer B entered into a swap with each other under which each was required to collect $100 from the other in initial margin without segregation, each would collect $100 in initial margin from the other and no net initial margin would be exchanged. In the case of a bankruptcy of dealer B, dealer A would be permitted to set off the $100 loss that may be incurred in replacing the swap against the $100 in initial margin it “collected” from dealer B, but then would face the potential loss of the $100 in initial margin it provided to dealer B, for which it would only have a claim in bankruptcy. If instead the initial margin for such a swap had been segregated, dealer A would be permitted to set off the $100 loss that may be incurred in replacing the swap against the $100 in initial margin that dealer B pledged to dealer A at a third-party custodian, and dealer A could also recover the $100 in initial margin that it pledged to dealer B at a third-party custodian, with the result that dealer A would incur no loss upon dealer B's bankruptcy.

Swap entities that engage in cleared swap transactions will be required to post initial margin to the CCP. Consequently, the initial margin that is posted on cleared transactions will not be available for rehypothecation by swap entities. Allowing for rehypothecation of initial margin by swap entities would create an incentive for swap entities to engage in non-cleared transactions even though other provisions of Dodd-Frank Act are intended to promote central clearing of swaps. However, the segregation of initial margin is likely to significantly reduce the availability of liquid assets to covered swap entities to meet payment obligations, as liquid assets held or pledged as the initial margin would be unavailable to the swap entity for other purposes. The requirement to segregate initial margin could result in covered swap entities having to seek alternative methods of funding. The loss in liquidity could be severe, and could require covered swap entities to raise liquidity through other sources.

The Agencies are concerned that not requiring segregation at the outset may cause covered swap entities that incur a severe loss due to credit or market events to face liquidity challenges because their counterparties may require segregation immediately after the loss, depleting the covered swap entity's liquid assets before it can raise additional funds through other means.

Requiring swap entities to segregate at the outset addresses this concern at the time a swap entity suffers a loss, but depletes the liquid assets at the inception of the swap transaction—a time when the swap entity is more likely to be able to raise additional liquid funds. The Agencies request comment on whether the proposed segregation requirement is appropriate, or whether an alternative approach would better reflect the purposes of sections 731 and 764 of the Dodd-Frank Act. In particular, the Agencies request comment on the following questions:

Although the agreements between the counterparties might not allow for requests for segregation after a swap transaction has been confirmed, as a practical matter counterparties might refuse to enter into any additional transactions with a financially-stressed swaps entity absent an accommodation to segregate some amount of initial margin for the existing portfolio of swaps between the two parties.

Question 65(a).

Is it necessary to require segregation of initial margin in order to address the systemic risk issues discussed above? 65(b) What alternatives to segregation would effectively address these systemic risk issues? 65(c) As an alternative to requiring segregation at the outset, should the Agencies impose rules that provide additional time for a swap dealer to raise funds without requiring segregation?

Question 66(a).

What are the potential operational, liquidity and credit costs of requiring segregation of initial margin by swap entities? 66(b) What would be the expected liquidity impact and cost of the proposed segregation requirement on market participants? How can the impact of the proposed rule on the liquidity and costs of swaps market participants be mitigated?

Question 67.

Is segregation of initial margin and not variation margin sufficient to achieve the purposes of sections 731 and 764 of the Dodd-Frank Act? If not, how might such purposes be achieved?

Question 68(a).

Are the limitations placed on rehypothecation and reinvestment under the proposed rule appropriate or necessary? 68(b) What additional or alternative limitations may be appropriate? 68(c) Should certain forms of rehypothecation (

e.g.,

the lending of securities pledged as collateral) or additional types of reinvestment be permitted?

Question 69(a).

Is the proposed rule's requirement that the custodian must be located in a jurisdiction that applies the same insolvency regime to the custodian as would apply to the covered swap entity necessary or appropriate? 69(b) What additional or alternative requirements regarding the location of the custodian may be appropriate?

H. Section __.8: Approved Initial Margin Models

Section __.8 of the proposed rule contains modeling standards that an initial margin model must meet in order for a covered swap entity to calculate initial margin under such a model. Generally, the modeling standards are consistent with current regulatory rules and best practices for such models in the context of risk-based capital rules applicable to insured depository institutions and bank holding companies, and are no less conservative than those generally used by derivatives clearing organizations and clearing agencies.

As a result, the Agencies preliminarily believe that these modeling standards should ensure that a non-cleared swap does not pose a greater systemic risk than a cleared swap. In particular, because non-cleared swaps are expected to be less liquid than cleared swaps, the proposed rule specifies a minimum time horizon for the initial margin model of 10 business days, compared with a typical requirement of 3 to 5 business days used by derivatives CCPs.

This conservative approach also incorporates the practices associated with model validation, independent review and other qualitative requirements associated with the use of internal models for regulatory capital purposes.

See

proposed rule § __.8(d)(1).

The proposed rule permits a covered swap entity to use an internal initial margin model that reflects offsetting exposures, diversification, and other hedging benefits within four broad risk categories (commodity, credit, equity,

foreign exchange/interest rates) when calculating initial margin for a particular counterparty if the relevant swaps or security-based swaps are executed under the same qualifying master netting agreement.

The proposed rule does

not

permit an initial margin model to reflect offsetting exposures, diversification, or other hedging benefits

across

broad risk categories.

It is the preliminary view of the Agencies that the correlations of exposures across broad risk categories are not stable enough to be incorporated into a regulatory margin requirement.

See

proposed rule § __.8(b).

Id.

The Agencies request comment on whether the standards for initial margin models specified in the proposed rule are sufficient to ensure the integrity of initial margin calculations using such a model. In particular, the Agencies request comment on the following questions:

Question 70(a).

Should such models be limited to models based on value-at-risk concepts, or are other models appropriate to measure initial margin? 70(b) If so, how should those models apply and be incorporated into the various aspects of the proposed rule?

Question 71(a).

Should offsetting exposures, diversification, and other hedging benefits be recognized more broadly across substantially dissimilar asset classes? 71(b) If so, what limits, if any, would be placed on the recognition of offsetting exposures, diversification, and other hedging benefits, and how could these be measured, monitored and validated on an ongoing and consistent basis across substantially dissimilar asset classes?

Question 72(a).

Should the minimum time horizon vary across swaps? 72(b) For example, should it vary based on the broad asset classes: commodity, credit, equity, and foreign exchange/interest rate? 72(c) If so, how should the horizons differ and what would be the basis for the different horizons?

1. Stress Calibration

In addition to a time horizon of 10 trading days, the proposed rule requires the initial margin model to be calibrated to a period of financial stress.

Calibration to a stress period ensures that the resulting initial margin requirement is robust to a period of financial stress during which swap entities and financial counterparties are more likely to default. Such calibration also reduces the systemic risk associated with any increase in margin requirements that might occur in response to a large increase in volatility during a period of financial stress.

See

proposed rule § __.8(d)(11).

The Agencies request comment on whether the proposed requirement that an initial margin model take into account financial stress is appropriate given the purpose the initial margin model is intended to serve. In particular, the Agencies request comment on the following questions:

Question 73.

Can initial margin models be robustly calibrated to a stress period in a transparent and consistent manner?

Question 74.

Are there any other systemic risk implications of requiring that initial margin be calibrated to a period of financial stress rather than to a recent or normal historical period?

Question 75.

Is the proposed prudential standard for initial margin of a 99th percentile price move over a 10-day horizon, calibrated using historical data incorporating a period of significant financial stress, appropriate?

Question 76.

Is a 10-day horizon sufficient to cover the likely liquidation period on non-cleared swaps?

Question 76.

Will the requirement to calibrate to a period of significant financial stress reduce the potential procyclicality of the margin requirement sufficiently? For example, would a minimum margin requirement as a backstop to the modeled initial margin amounts be a prudent approach to addressing procyclicality concerns?

Question 77.

Is “period of significant financial stress” a well-understood concept? How might it be clarified?

Question 78.

What would be the benefits and costs of replacing the requirement to calibrate the initial margin model using a period of significant financial stress with a requirement to calibrate the initial margin model using a longer historical data sample (such as 10 years), as an alternative way to reduce the potential procyclicality of the margin requirement?

Question 79.

Should market participants be able to comply with the requirement to calibrate the initial margin requirement to a historical period of significant financial stress for newer products with little, if any, market history? If so, how?

2. Benchmarking

The proposed rule requires that an initial margin model used for calculating initial margin requirements be benchmarked periodically against observable margin standards to ensure that the initial margin required is not less than what a derivatives clearing organization or a clearing agency would require for similar transactions.

This benchmarking requirement is intended to insure that any initial margin amount produced by an initial margin model is subject to a readily observable minimum. It will also have the effect of limiting the extent to which the use of initial margin models might disadvantage the movement of certain types of derivatives to CCPs by setting lower initial margin amounts for non-cleared transactions than for similar cleared transactions.

See

proposed rule § __.8(d)(14).

The Agencies request comment on the proposed requirement for covered swap entities to benchmark any initial margin model to a model used by a derivatives clearing organization or clearing agency model for calculating initial margin, as well as the following questions:

Question 80.

What are the operational costs associated with the benchmarking exercise?

Question 81.

Can portfolio effects be captured during the benchmarking exercise?

Question 82.

How would a banking organization fulfill the requirement in the event that a derivatives clearing organization or clearing agency does not clear a similar derivative transaction?

I. Section __.9: Application of Margin Requirements to Certain Foreign Covered Swap Entities

Section __.9 of the proposed rule addresses the manner in which the proposed rule's margin requirements apply to certain foreign covered swap entities. In the absence of § __.9, the proposed rule's margin requirements would apply to all of a covered swap entity's non-cleared swap and non-cleared security-based swap transactions, without regard to whether (i) the covered swap entity is organized under U.S. or foreign law or (ii) the covered swap entity's counterparty is located inside or outside of the United States. However, the potential application of the margin rules to foreign covered swap entities, or to transactions by U.S. covered swap entities with foreign counterparties, raises several important questions. First, the potential application of the proposed rule to activities conducted by a foreign covered swap entity wholly outside of the United States raises questions regarding the permissible territorial scope of the proposed rule.

Second, to the extent that the proposed margin requirements apply to transactions involving foreign covered swap entities or foreign counterparties, such application could subject these transactions to multiple, and potentially conflicting, margin requirements established by U.S. and foreign regulators. Third, the potentially different treatment of U.S. covered swap entities and foreign covered swap entities raises questions of competitive equality among the two types of firms.

Section 2(i) of the Commodity Exchange Act, as amended by section 722 of the Dodd-Frank Act, provides that the provisions of the Commodity Exchange Act relating to swaps “shall not apply to activities outside of the United States unless those activities * * * have a direct and significant connection with activities in, or effect on, commerce of the United States.”

With respect to U.S. covered swap entities, the Agencies propose to apply the margin requirements to U.S. covered swap entities' swap and security-based swap transactions without regard to whether the counterparty is located inside or outside the United States. This approach acknowledges that the foreign swap and security-based swap transactions of a U.S. covered swap entity pose no lesser risk to the covered swap entity's safety and soundness and to financial stability based on the location of the counterparty. The proposed rule applies that same approach to covered swap entities that are foreign subsidiaries and offices of U.S. firms.

With respect to foreign covered swap entities, the Agencies propose to exclude certain qualifying foreign derivative transactions of such entities from application of the proposed rule's margin requirements. Specifically, § __.9 of the proposed rule provides that the proposed rule's margin requirements would not apply to any “foreign non-cleared swap or foreign non-cleared security-based swap” of a “foreign covered swap entity,” as those terms are defined in § __.9 of the proposed rule.

This proposed approach limits the extra-territorial application of the margin requirements while preserving, to the extent possible, competitive equality among U.S. and foreign firms in the United States.

See

proposed rule § __.9(a).

For these purposes, the proposed rule defines a “foreign non-cleared swap or foreign non-cleared security-based swap” as a non-cleared swap or non-cleared security-based swap with respect to which: (i) The counterparty to the foreign covered swap entity is not a company organized under the laws of the United States or any State, not a branch or office of a company organized under the laws of the United States or any State, and not a person resident in the United States; and (ii) performance of the counterparty's obligations to the foreign covered swap entity under the swap or security-based swap has not been guaranteed by an affiliate of the counterparty that is a company organized under the laws of the United States or any State, a branch of a company organized under the laws of the United States or any State, or a person resident in the United States.

As a result, foreign swaps and security-based swaps would generally only include transactions where the counterparty is not organized under U.S. law or otherwise located in the United States, and no U.S. affiliate of the counterparty has guaranteed the counterparty's obligations under the transaction.

See

proposed rule § __.9(b).

Under the proposed rule, swap and security-based swaps with

U.S. counterparties

are subject to the proposed rule's margin requirements regardless of whether the covered swap entity is U.S. or foreign.

The additional requirement that no U.S. affiliate guarantee the counterparty's obligation is intended to exclude instances where such an affiliate has, through a guarantee, effectively assumed ultimate responsibility for the performance of the counterparty's obligations under the transaction. In particular, the Agencies are concerned that without such a requirement, swaps and security-based swaps with a U.S. counterparty could be structured, through the use of an overseas affiliate, in a manner that would evade application of the proposed margin requirements to U.S. transactions. Transactions guaranteed by a U.S. affiliate would also have direct and significant connection with activities in, and effect on, commerce of the United States.

The proposed rule defines a “foreign covered swap entity” as a covered swap entity that: (i) Is not a company organized under the laws of the United States or any State; (ii) is not a branch or office of a company organized under the laws of the United States or any State; (iii) is not a U.S. branch, agency or subsidiary of a foreign bank; and (iv) is not controlled, directly or indirectly, by a company that is organized under the laws of the United States or any State.

Accordingly, only a covered swap entity that is organized under foreign law and not controlled, directly or indirectly, by a U.S. company would be eligible for treatment as a foreign covered swap entity for these purposes; neither a foreign branch of a U.S. insured depository institution nor a foreign subsidiary of a U.S. company would be considered a foreign covered swap entity under the proposed rule. In cases where a U.S. company has a foreign subsidiary that is a covered swap entity, the proposed rule would treat that foreign subsidiary in the same manner as a U.S. covered swap entity for purposes of the margin requirements because the U.S. parent company's ownership of the subsidiary is likely to expose the U.S parent company, as a result of legal, contractual or reputational factors, to the risks of the foreign subsidiary's derivatives activities. Transactions of a foreign subsidiary of a U.S. company would also have direct and significant connection with activities in, and effect on, commerce of the United States. Similarly, neither a U.S. branch of a foreign bank nor a U.S. subsidiary of a foreign company would be a foreign covered swap entity under the proposed rule.

See

proposed rule § __.9(c).

The Agencies request comment on the proposed rule's application to the U.S. and foreign swap and security-based swap activities of U.S. covered swap entities and foreign swap entities, respectively. In particular, the Agencies request comment on the following questions:

Question 83.

Does the proposed rule's treatment of the swap and security-based swap transactions of foreign covered swap entities appropriately limit application of the margin requirements in a manner consistent with the territorial scope of sections 731 and 764 of the Dodd-Frank Act?

Question 84(a).

Is the proposed rule's treatment of the foreign swap and security-based swap transactions of U.S. covered swap entities appropriate? 84(b) Should such transactions be subject to the same exclusion that has been proposed for the foreign swap and security-based swap transactions of foreign covered swap entities? 84(c) If so, why?

Question 85(a).

Should the proposed rule expand the definition of foreign covered swap entity to include (i) the foreign subsidiaries of U.S. companies or (ii) the foreign branches of U.S. insured depository institutions? 85(b) If so, why? 85(c) How could the potential risks to the U.S. parent company or insured depository institution related to its subsidiary or branch's activity be limited or eliminated? 85(d) Is this operationally feasible?

Question 86.

What impact is the proposed rule's treatment of the foreign swap and security-based swap transactions of U.S. covered swap entities likely to have on the structure, management, and/or competitiveness of U.S. covered swap entities?

Question 87(a).

Is the proposed rule's definition of a foreign swap or security-based swap transaction appropriate? 87(b) In particular, is the requirement that no U.S. affiliate guarantee the

foreign counterparty's obligations under the swap or security-based swap transaction appropriate? 87(c) Would an alternative definition more appropriately differentiate between U.S. and foreign counterparties for these purposes? 87(d) If so, what should that definition be?

Question 88(a).

Is the proposed rule's definition of a foreign covered swap entity appropriate? 88(b) Would an alternative definition more appropriately differentiate between U.S. and foreign counterparties for these purposes? 88(c) If so, what should that definition be?

Question 89(a).

Is the proposed rule's application of the margin requirements to all U.S. swaps and security-based swaps of a covered swap entity, regardless of whether that covered swap entity is U.S. or foreign, appropriate? 89(b) Should the proposed rule treat such transactions differently? 89(c) If so, how?

Question 90.

What impact is the proposed rule's treatment of the swap and security-based swap transactions of foreign covered swap entities likely to have on the structure, management, and/or competitiveness of foreign covered swap entities?

J. Section __.10: Capital

The proposed rule generally requires a covered swap entity to comply with regulatory capital rules already made applicable to that covered swap entity as part of its prudential regulatory regime, as follows:

• In the case of insured depository institutions, the capital adequacy guidelines that are applicable to the covered entity and have been adopted by the appropriate Federal banking agency under section 38 of the Federal Deposit Insurance Act (12 U.S.C. 1831o);

• In the case of a bank holding company or savings and loan holding company (on or after the transfer established under Section 311 of the Dodd-Frank Act), the capital adequacy guidelines applicable to bank holding companies under the Board's Regulation Y (12 CFR part 225);

• In the case of a foreign bank or the U.S. branch or agency of a foreign bank, the capital rules that are made applicable to such covered entity pursuant to § 225.2(r)(3) of the Board's Regulation Y (12 CFR 225.2(r)(3);

• In the case of an Edge corporation or an Agreement corporation, the capital adequacy guidelines that are made applicable to an Edge corporation engaged in banking pursuant to § 211.12(c)(2) of the Board's Regulation K (12 CFR 211.12(c)(2);

• In the case of any “regulated entity” under the Federal Housing Enterprises Financial Safety and Soundness Act of 1992 (

i.e.,

Fannie Mae and its affiliates, Freddie Mac and its affiliates, and the Federal Home Loan Banks), the risk-based capital level or such other amount applicable to the covered swap entity as required by the Director of FHFA pursuant to 12 U.S.C. 4611;

• In the case of Farmer Mac, the capital adequacy regulations set forth in 12 CFR part 652; and

• In the case of any Farm Credit System institution (other than Farmer Mac), the capital regulations set forth in 12 CFR part 615.

See

proposed rule § __.10.

The Agencies have preliminarily determined that compliance with these regulatory capital requirements is sufficient to offset the greater risk to the swap entity and the financial system arising from the use of non-cleared swaps, helps ensure the safety and soundness of the covered swap entity, and is appropriate for the greater risk associated with the non-cleared swaps and non-cleared security-based swaps held as a covered swap entity. In particular, the Agencies note that the capital rules incorporated by reference into the proposed rule already address, in a risk-sensitive and comprehensive manner, the safety and soundness risks posed by a covered swap entity's derivatives positions.

In addition, the Agencies preliminarily believe that these capital rules sufficiently take into account and address the risks associated with the derivatives positions that a covered swap entity holds and the other activities conducted by a covered swap entity.

For example, under the banking agencies' capital adequacy standards for banks and bank holding companies based on the first Basel Accord, interest-rate, exchange-rate, commodity, and equity-linked derivative contracts that are not traded on an exchange are subject to a capital charge based on type of contract, remaining maturity, and the risk category of the counterparty to the contract.

See

12 CFR part 3, Appendix A § 3(b)(7) (OCC); 12 CFR parts 208 and 225, Appendix A § III.E (Board); 12 CFR part 325, Appendix A § II.E (FDIC). As another example, under the bank agencies' advanced risk-based capital adequacy standards based on the advanced approaches of the Basel II Accord (“advanced approaches”), banks and bank holding companies that use the advanced approaches determine capital requirements for over-the-counter derivatives based on a formula that takes into account collateral in mitigating counterparty credit risk.

See

12 CFR part 3, Appendix C, part IV (OCC); 12 CFR part 208, Appendix F, part IV and 12 CFR part 225, Appendix G, part IV (Board); and 12 CFR part 325, Appendix D, part IV (FDIC). The FCA's capital requirements for FCS institutions other than Farmer Mac expressly address derivatives transactions.

See

12 CFR 615.5201 and 615.5212. The FCA's capital requirements for Farmer Mac indirectly address derivatives transactions in the operational risk component of the statutorily mandated risk-based capital stress test model.

See

12 CFR part 652 Subpart B Appendix A. The FCA, through the Office of Secondary Market Oversight, closely monitors and supervises all aspects of Farmer Mac's derivatives activities, and the FCA believes existing requirements and supervision are sufficient to ensure safe and sound operations in this area. However, the FCA is considering enhancements to the model and in the future may revise the model to more specifically address derivatives transactions.

See footnote 33,

supra,

for a discussion of the basis for FHFA's preliminary view that the reference to existing statutory authority is sufficient to address the risks discussed in the text above as to the Enterprises notwithstanding their current conservatorship status.

The Agencies request comment regarding whether application of these capital regimes is appropriate.

Question 91.

Is an alternative or additional capital requirement appropriate for some or all of the covered swap entities subject to the proposed rule?

Question 92.

Are there particular issues or concerns raised in the context of foreign banks or their U.S. branches and agencies that would be better addressed through a different approach to the capital requirement for such entities?

K. Section __.11: Special Requirements for Transactions Between Swap Entities and Regulated Entities

FHFA and FCA (but not the other Agencies) are proposing an additional provision, § __.11 of FHFA's and FCA's proposed rules. Proposed § __.11 would require that any entity that is regulated by FHFA or FCA, but is not itself a covered swap entity, collect initial margin and variation margin from its counterparty when entering into a non-cleared swap or non-cleared security-based swap with a swap entity.

Regulated entities subject to this provision include the Federal Home Loan Banks, Fannie Mae and its affiliates, Freddie Mac and its affiliates, and all Farm Credit System institutions including Farmer Mac (collectively, regulated entities, and each a regulated entity). Regulated entities that are swap entities would be subject to §§ 1 through 9 of the proposed rule by virtue of being covered swap entities. This section also does not apply to swaps entered into between regulated entities and end users.

See

FCA and FHFA proposed rule § __.11. FCA and FHFA note that in sections III.C and III.D of this notice of proposed rulemaking, the Agencies have requested comment on alternative approaches to margin requirements, including whether covered swap entities should be required to post margin to end users. In the event such an alternative approach is adopted as part of a final rule, as to both initial and variation margin requirements, FCA and FHFA note that this proposed § __.11 may not need to be adopted as part of that final rule.

Proposed § __.11 is consistent with the risk-based approach to margin

proposed by the Agencies and parallels the requirements that swap entities collect initial and variation margin from their counterparties. Moreover, this approach recognizes that a default by a swap counterparty to a regulated entity could adversely affect the safe and sound operations of the regulated entity. The requirement reflects current practice in that the regulated entities generally obtain collateral to secure their swaps exposure to swap dealer counterparties, although current practice generally does not include posting of initial margin by or to any counterparty.

FHFA and FCA are proposing these provisions pursuant to each agency's role as safety and soundness regulator for its respective regulated entities, and each agency's authority to ensure that the regulated entities operate in a safe and sound manner, including that they maintain adequate capital and internal controls, that their activities foster liquid, efficient, competitive and resilient national finance markets for housing, agriculture, and rural markets, and that they carry out their public policy missions through authorized activities.

See

12 U.S.C. 2154, 2248, 2252, 4513, 4526.

Section __.11(a)(1) of the proposed rule requires a regulated entity to collect initial margin when it enters into a swap transaction with a swap entity. The proposal provides that the amount of initial margin the regulated entity must collect shall be in accordance with § __.3 of the proposed rule, which permits the use of either an initial margin model or the use of a standardized “look up” table specifying the minimum initial margin that must be collected as a percentage of the notional amount of the transaction. The minimum initial margin levels set out in Appendix A apply only in the absence of an initial margin model. FHFA and FCA, however, seek comment on whether a minimum initial margin requirement should apply as a backstop even to modeled initial margin amounts, as a prudent approach to address concerns about procyclicality and competitive pressures to reduce margin requirements. If not, how should such concerns be addressed?

Section __.11(a)(1) of the proposed rule permits a regulated entity to use its initial margin model to determine initial margin and provides that if the regulated entity does not have an initial margin model, it may engage a third party to calculate initial margin on its behalf, provided that the third party is itself independent of the swap entity that is the counterparty to the transaction. Any initial margin model used to determine margin posted to a regulated entity must meet all of the requirements of § __.8 of the proposed rule. FHFA and FCA preliminarily believe that permitting a swap entity to use its own model to calculate the amount of initial margin it would be required to post to a regulated entity may introduce a conflict of interest to the transaction. That concern could be addressed by establishing a process through which the regulated entity could verify the reasonableness of the counterparty's model calculation. FHFA and FCA each seeks comment on whether it should allow its regulated entities to use the counterparty's model to calculate initial margin, and if so, what provisions should be included to mitigate conflicts of interest.

Section __.11(a)(2) of the proposed rule requires that a regulated entity collect variation margin daily from the swap entity in accordance with the requirements of § __.4 of the proposed rule, which permits the amounts of variation margin posted to be adjusted to account for qualifying master netting agreements and applies a minimum transfer amount of $100,000.

Section __.11(b) of the proposed rule requires that any regulated entity entering into a non-cleared swap or a non-cleared security-based swap with a swap entity must execute trading documentation with such counterparty in accordance with § __.5 of the proposed rule. Section __.11(c) of the proposed rule provides that any collateral that a regulated entity is required to collect as initial or variation margin must meet the eligible collateral requirements of § __.6 of the proposed rule. That section applies the same eligibility requirements to the regulated entities that are required of the swap entities.

Section __.11(d) of the proposed rule provides that a regulated entity must require that any initial margin it posts to a counterparty be held by an independent custodian. That provision is consistent with the requirement in § __.7 of the proposed rule that a covered swap entity require segregation with an independent custodian of any initial margin that it posts to another swap entity. Section __.11(d) of the proposed rule applies this segregation requirement to variation margin as well as initial margin and thereby reflects current practice of at least some of the regulated entities. FHFA and FCA seek comments on whether such a requirement should be applied to variation margin and if it is not applied, how the regulated entities would be protected in the event variation margin is posted to a swap entity that subsequently fails.

IV. Quantitative Impact of Margin Requirements

The proposed rule would apply the initial margin and variation margin requirements to non-cleared swaps and security-based swaps that are entered into by a covered swap entity after the effective date, which is proposed to be 180 days after publication of a final rule in the

Federal Register

. The proposed rule would not require an immediate or retroactive application of initial margin or variation margin for any derivative transaction entered into prior to the effective date of the final rule.

Because the requirements would not be applied retroactively, no new initial margin or variation margin requirements would be imposed on derivatives transactions entered into prior to the effective date until such time as those transactions are rolled-over or renewed. The only requirements that would apply to a pre-effective date covered derivative would be the initial margin and variation margin requirements to which the parties to the transaction had previously agreed to by contract.

The new requirements will have an impact on the costs of engaging in new swap transactions. In particular, the proposed rule sets out requirements for initial and variation margin that represent a significant change from current industry practice in many circumstances. Assessing the quantitative impact of the proposed requirements is particularly difficult in light of the wide ranging and as yet undetermined changes that are occurring to the derivatives market as a result of regulatory reform. Specifically there is significant uncertainty with respect to (i) which entities would be classified as swap entities; (ii) the extent to which existing derivatives would be rolled-over or renewed; and (iii) the extent to which derivatives currently traded on an over-the-counter basis will move to central clearing by a CCP. In addition, there are a number of specific and technical aspects of the proposed rule, such as number and composition of counterparties that would be classified as high-risk financial end users, low-risk financial end users, and nonfinancial end users, respectively, that are difficult to assess without a large amount of highly detailed data on the size of derivative positions as well as the underlying rationale for maintaining those positions. These and other complicating factors make it difficult to make precise statements about the quantitative impact of the

margin rule specified under the proposed rule.

Accordingly, the Agencies request commenters to provide their own detailed quantitative impact analyses. The Agencies encourage commenters to include the following elements in their analyses categorized between swaps entities, high-risk financial end users, low-risk financial end users, and nonfinancial end users: (i) Required initial margin if internal models were applied; (ii) required initial margin if the standardized chart in Appendix A were applied; (iii) required variation margin; (iv) the expected costs of, or additional liquidity required by, the initial margin and variation margin requirements; and (v) the potential benefits of the initial margin and variation margin requirements to covered swap entities, their counterparties, and financial stability. The analyses should also (i) address operational and other business related costs associated with implementing the proposed rule and (ii) take into consideration and disclose the expected effect of the likely clearing of certain derivative transactions through CCPs in the future.

In order to better understand the effect that broader clearing requirements will have on the impact of the proposed rules, the Agencies also request comment on the levels of covered derivatives, including the roll-over or renewal of prior derivatives that would become covered under the proposed rule, that can be expected over the following time horizons after the effective date: (i) 1 year, (ii) 3 years, and (iii) 5 years. To maximize the usefulness of such comments, the Agencies request that commenters break down such projections by covered derivatives that are likely to be cleared and uncleared, as well as by product class.

V. Request for Comments

The Agencies are interested in receiving comments on all aspects of the proposed rule.

VI. Solicitation of Comments on Use of Plain Language

Section 722 of the Gramm-Leach-Bliley Act, Public Law 106-102, section 722, 113 Stat. 1338, 1471 (Nov. 12, 1999), requires the OCC, Board and FDIC to use plain language in all proposed and final rules published after January 1, 2000. The OCC, Board and FDIC invite your comments on how to make this proposal easier to understand. For example:

• Have we organized the material to suit your needs? If not, how could this material be better organized?

• Are the requirements in the proposed regulation clearly stated? If not, how could the regulation be more clearly stated?

• Does the proposed regulation contain language or jargon that is not clear? If so, which language requires clarification?

• Would a different format (grouping and order of sections, use of headings, paragraphing) make the regulation easier to understand? If so, what changes to the format would make the regulation easier to understand?

• What else could we do to make the regulation easier to understand?

VII. Administrative Law Matters

A. Paperwork Reduction Act Analysis

Request for Comment on Proposed Information Collection

Certain provisions of the proposed rule contain “collection of information” requirements within the meaning of the Paperwork Reduction Act of 1995 (“PRA”), 44 U.S.C. 3501-3521. In accordance with the requirements of the PRA, the Agencies may not conduct or sponsor, and the respondent is not required to respond to, an information collection unless it displays a currently valid Office of Management and Budget (OMB) control number. The information collection requirements contained in this joint notice of proposed rulemaking have been submitted by the FDIC, OCC, and FHFA to OMB for approval under section 3506 of the PRA and § 1320.11 of OMB's implementing regulations (5 CFR part 1320). The Board reviewed the proposed rule under the authority delegated to the Board by OMB.

Comments are invited on:

(a) Whether the collections of information are necessary for the proper performance of the agencies' functions, including whether the information has practical utility;

(b) The accuracy of the estimates of the burden of the information collections, including the validity of the methodology and assumptions used;

(d) Ways to minimize the burden of the information collections on respondents, including through the use of automated collection techniques or other forms of information technology; and

(e) Estimates of capital or start up costs and costs of operation, maintenance, and purchas

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