Many of our clients are receiving new documentation requests from dealers in order to comply with changing regulatory requirements affecting derivatives trading. These requests relate to required margin for uncleared swaps, European regulations pertaining to “bail-in” powers and stays in the exercise of remedies against insolvent financial institutions, and the U.S. dividend equivalent tax under Section 871(m) of the Internal Revenue Code
1. Required Margin for Uncleared Swaps.
Effective on September 1, 2016, the Commodity Futures Trading Commission required swap dealers and major swap participants to exchange amounts determined pursuant to regulation of variation margin on uncleared derivatives trades between themselves. Other market participants will be gradually brought within the scope with respect to both initial margin and variation margin. The European Union, Canada and Japan are adopting similar requirements.
The rules for variation margin, which must be exchanged daily to reflect changes in the mark-to-market valuation of swap contracts, will apply to all market participants from March 1, 2017 in all jurisdictions. The rules are not a dramatic change from what has been the case in well-negotiated ISDA Credit Support Annexes heretofore, in that they rule out a “Threshold” for determining collateral, they require a daily mark-to-market, they limit the Minimum Transfer Amount, and they specify what collateral is eligible and applicable haircuts for such collateral.
The procedures being followed to implement the new variation margin rules by March 1, 2017 vary between swap dealers and sometimes within the same swap dealer for different customers. Some swap dealers are suggesting adherence to the ISDA 2016 Variation Margin Protocol. Other dealers, perhaps in response to the complexities of that Protocol and its requirement to match questionnaires, are using bilateral amendments. In either case, we can assist clients in this process.
The rules for initial (or “upfront”) margin will be phased in over several years. ISDA has launched the ISDA Standard Initial Margin Model (ISDA SIMMTM), an industry standard methodology to calculate initial margin for non-cleared derivatives trades. Its purpose is to eliminate issues arising from the application of different proprietary models and to create transparency on a global basis.
Certain swap dealers are requesting that their customers complete an ISDA Regulatory Margin Self-Disclosure Letter. The purpose of this document is to allow the swap dealer to know how to treat the customer under the rules for margin, particularly with respect to the phased implementation of the forthcoming initial margin rules.
2. European Bail-in Regulations and Resolution Stays.
European regulations have promulgated regulations which require regulated entities such as banks and dealers in their jurisdictions to obtain agreements from their customers acknowledging that the customers will be subject to the rules of European insolvency regimes in the event of the insolvency of a European bank or dealer, notwithstanding that the customer’s agreement with such bank or dealer may be governed by other laws, such as those of the State of New York.
The ISDA 2016 Bail-in Art 55 BRRD Protocol implements the required agreement in respect of the European jurisdiction’s “bail-in” powers, whereby a customer of an insolvent bank or dealer may be required to convert its financial claim against such bank or dealer into an equity interest in such bank or dealer.
The ISDA Resolution Stay Jurisdictional Modular Protocol implements the required agreement in respect of a European jurisdiction’s power to temporarily delay the exercise of certain termination rights and remedies against an insolvent regulated entity.
3. ISDA 2015 Section 871(m) Protocol.
This Protocol ensures that the “long” party will bear the liability for any dividend equivalent tax in respect of dividends on U.S. equities imposed pursuant to Section 871(m) of the U.S. Internal Revenue Code of 1986, as amended. Certain provisions of that Section took effect with respect to any transaction entered into on or after January 1, 2017.
4. Conclusion.
As a rule, investment fund clients do not have any choice except to comply with the new documentation initiatives discussed above if they want to be able to continue trading with the banks or dealers requesting such documentation. We can assist, however, in helping you to determine whether you do have any alternatives, and with ensuring that the documentation requests are reasonable and market standard.
If you have any questions regarding the foregoing, please contact Craig Hickernell (212-574-1399), Lauri Goodwyn (212-574-1249), or Daniel Bresler (212-574-1203), or an attorney in the Investment Management Group at Seward & Kissel LLP, or (in respect of the dividend equivalent tax) an attorney in the Tax Group at Seward & Kissel LLP.
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If you have any questions regarding the matters covered in this memo, please contact any of the partners and counsel listed below or your primary attorney in Seward & Kissel’s Investment Management Group.
