Futures & Derivatives Law

REPORT The Journal on the Law of Investment & Risk Management Products Futures & Derivatives Law A Survey of Portfolio Margining under Dodd-Frank BY JONATHAN CHING AND JOEL TELPNER CONTINUED ON PAGE 3 September 2014 n Volume 34 n Issue Jonathan Ching has significant experience working with derivatives and their practical applications in trading and capital markets. He is involved in the structuring, negotiation and execution of OTC derivatives and synthetic financial products, and works regularly with capital markets, litigation, bankruptcy and finance teams at Jones Day on the derivatives aspects of litigation, acquisitions, financing transactions and corporate restructurings. His transactional practice includes the financing of various assets through lending arrangements, repos, derivatives, and other structured solutions. He also advises non-u.s. corporations and financial firms on compliance with various requirements for OTC derivatives under Dodd-Frank, foreign exchanges in their U.S. offerings of futures products, and non-financial corporate entities regarding the commercial end-user exception. Joel Telpner represents financial institutions, derivative dealers, Fortune 500 corporations, hedge funds, pension funds, and other end-users in designing, structuring, and negotiating complex derivative and structured finance transactions. Joel advises clients on a broad variety of financial products and transactions, including credit, equity, and commodity derivatives; synthetic products; credit and equity-linked products; hedge fund-linked products; and structured and leveraged finance transactions. In addition, Joel advises financial institutions and end-users on understanding and complying with the regulatory requirements arising from the financial reform legislation, as well as new opportunities resulting from the legislation. Executive Summary: Global regulatory reforms arising from the 2008 financial crisis resulted in a new market structure for overthe-counter (OTC) derivatives. This new structure, designed to address the twin goals of transparency and risk mitigation, has disrupted traditional portfolio margining by imposing mandatory clearing requirements for much of the OTC derivatives market. Although many portfolio margining arrangements, such as those employed in securities and futures markets in the U.S., were specifically permitted by the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank), they have taken some time to develop in practice. In this article we discuss examples of portfolio margining which have existed for years in equity and fixed income markets, provide an update on portfolio margining options which are now being offered for cleared OTC derivatives, and conclude with a discussion of the policy rationale for continuing to encourage portfolio margining. Article REPRINT Reprinted from the Futures & Derivatives Law Report. Copyright 2014 Thomson Reuters. For more information about this publication please visit legalsolutions.thomsonreuters.com ARTICLE REPRINT

September 2014 n Volume 34 n Issue 8 2014 Thomson Reuters. This publication was created to provide you with accurate and authoritative information concerning the subject matter covered, however it may not necessarily have been prepared by persons licensed to practice law in a particular jurisdiction. The publisher is not engaged in rendering legal or other professional advice, and this publication is not a substitute for the advice of an attorney. If you require legal or other expert advice, you should seek the services of a competent attorney or other professional. For authorization to photocopy, please contact the Copyright Clearance Center at 222 Rosewood Drive, Danvers, MA 01923, USA (978) 750-8400; fax (978) 646-8600 or West s Copyright Services at 610 Opperman Drive, Eagan, MN 55123, fax (651)687-7551. Please outline the specific material involved, the number of copies you wish to distribute and the purpose or format of the use. For subscription information, please contact the publisher at: west.legalworkspublications@thomson.com Editorial Board STEVEN W. SEEMER Publisher, West Legal Ed Center RICHARD A. MILLER Editor-in-Chief, Prudential Financial Two Gateway Center, 5th Floor, Newark, NJ 07102 Phone: 973-802-5901 Fax: 973-367-5135 E-mail: richard.a.miller@prudential.com MICHAEL S. SACKHEIM Managing Editor, Sidley Austin LLP 787 Seventh Ave., 10019 Phone: (212) 839-5503 Fax: (212) 839-5599 E-mail: msackheim@sidley.com PAUL ARCHITZEL Wilmer Cutler Pickering Hale and Dorr CONRAD G. BAHLKE Strook & Strook & Lavan LLP ANDREA M. CORCORAN Align International, LLC West LegalEdcenter 610 Opperman Drive Eagan, MN55123 2014 Thomson Reuters One Year Subscription n 11 Issues n $752.04 (ISSN#: 1083-8562) W. IAIN CULLEN Simmons & Simmons London, England IAN CUILLERIER White & Case LLP New York WARREN N. DAVIS Sutherland Asbill & Brennan SUSAN C. ERVIN Davis Polk & Wardwell LLC RONALD H. FILLER New York Law School DENIS M. FORSTER THOMAS LEE HAZEN University of North Carolina at Chapel Hill DONALD L. HORWITZ North American Derivatives Exchange Chicago, IL PHILIP MCBRIDE JOHNSON DENNIS KLEJNA PETER Y. MALYSHEV Latham & Watkins, and ROBERT M. MCLAUGHLIN Fried, Frank, Harris, Shriver & Jacobson LLP CHARLES R. MILLS K&L Gates, LLP DAVID S. MITCHELL Fried, Frank, Harris, Shriver & Jacobson LLP RITA MOLESWORTH Willkie Farr & Gallagher PAUL J. PANTANO Cadwalader, Wickersham & Taft LLP GLEN A. RAE Banc of America Merrill Lynch KENNETH M. RAISLER Sullivan & Cromwell KENNETH M. ROSENZWEIG Katten Muchin Rosenman Chicago, IL THOMAS A. RUSSO American International Group, Inc. HOWARD SCHNEIDER Charles River Associates LAUREN TEIGLAND-HUNT Teigland-Hunt LLP PAUL UHLENHOP Lawrence, Kamin, Saunders & Uhlenhop Chicago, IL SHERRI VENOKUR Venokur LLC For authorization to photocopy, please contact the Copyright Clearance Center at 222 Rosewood Drive, Danvers, MA 01923, USA (978) 750-8400; fax (978) 646-8600 or West s Copyright Services at 610 Opperman Drive, Eagan, MN 55123, fax (651) 687-7551. Please outline the specific material involved, the number of copies you wish to distribute and the purpose or format of the use. This publication was created to provide you with accurate and authoritative information concerning the subject matter covered. However, this publication was not necessarily prepared by persons licensed to practice law in a particular jurisdication. The publisher is not engaged in rendering legal or other professional advice, and this publication is not a substitute for the advice of an attorney. If you require legal or other expert advice, you should seek the services of a competent attorney or other professional. Copyright is not claimed as to any part of the original work prepared by a United States Government officer or employee as part of the person s official duties. 2 2014 THOMSON REUTERS

September 2014 n Volume 34 n Issue 8 CONTINUED FROM PAGE 1 I. Portfolio Margining and OTC Swap Clearing In 2009, the Group of Twenty Finance Ministers and Central Bank Governors (G20) met to discuss regulatory responses to the global financial crisis of 2008. Among the many significant outcomes of the 2009 G20 summit was a global commitment to the clearing of OTC derivatives as a means of controlling systemic risk. Following the 2009 G20 summit, new regulations were proposed in the United States, the European Union and elsewhere across the globe to implement the clearing of OTC derivatives. 1 While these proposals have taken time to develop, in the U.S. mandatory clearing has been fully implemented for large parts of the OTC derivatives market. 2 Clearing in the context of OTC derivatives results in the novation of executed trades to a central counterparty (CCP) which then acts as the counterparty to each trade. CCPs also perform other functions such as calculating and collecting margin, trade reporting, and default management in the event a clearing member firm fails. Under the U.S. model for OTC derivatives clearing, customers are not direct clearing member of a CCP. Instead, they engage a futures commission merchant (FCM) to act as their clearing member at the CCP. Although the CCP is the counterparty to the trade, the FCM performs the critical task of collecting and delivering margin to the CCP and acting as guarantor for its customer s obligations to the CCP in the event of the customer s default. Once the OTC derivatives trade has been accepted by the CCP, the original parties to the trade no longer face each other directly. In this way, OTC clearing acts as a mitigant against counterparty risk of the kind that became apparent in the OTC derivatives market when Lehman Brothers failed in September 2008. In the event of the failure of an individual clearing member, the CCP will manage the defaulted clearing member s portfolio, transferring positions to solvent clearing members and arranging for the termination of positions which cannot be transferred. In this way, a CCP is designed to prevent the disruptive effects on a market when a large firm collapses. 3 As the U.S. clearing mandate took shape during 2011-2013, certain practical considerations came to light for market participants. Unlike the clearing of other financial products such as securities, clearing OTC derivatives requires a much greater focus on counterparty risk management. Further, OTC derivatives clearing requires market participants to create new documentation to govern their relationships, and new operational processes to facilitate credit limit checks, trade submission, and margin transfer. Additionally, because the initial clearing mandate in the U.S. was limited to certain interest rate swaps and credit default swap (CDS) indices, mandatory clearing resulted in the bifurcation of a customer s OTC derivatives portfolio into cleared and uncleared buckets, each with different margin requirements. At least in the short term, mandatory clearing has increased the cost to the end user of OTC derivatives in the form of upfront costs paid to its FCM for clearing the trades, and costs incurred due to an increase in the margin requirement for trades which are imposed by the CCP and not subject to negotiation. 4 In light of these increased costs, portfolio margining can play an important role. Fortunately, as described below in Part II-D, there is extensive precedent for portfolio margining and ample regulatory support. Dodd-Frank itself specifically recognized the importance of portfolio margining 5, and a number of CCPs are presently offering differing levels of portfolio margining or building out new offerings to help customers achieve better margin efficiency. While an integral part of this equation is the relationship between cleared and uncleared OTC derivatives portfolios (as well as between cleared OTC derivatives and other cleared futures products), in the absence of final rules on margin requirements for uncleared swaps, market efforts to date have focused on the potential for portfolio margining amongst cleared products. For example, ICE allows for portfolio margining between cleared CDS indices and cleared single name swaps. CME allows for portfolio margining across cleared interest rate swaps and certain cleared interest rate futures. These types of offerings have shown market participants the potential opportunities for margin optimization and efficiency in the world of mandatory clearing. Additionally, as jurisdictions outside the U.S. begin to implement their clearing mandates, the experience with portfolio margining programs implemented in the U.S. may provide useful guidance for other regulators. II. Portfolio Margining Arrangements Today A. What is Portfolio Margining? Margin provides protection to a party where its counterparty s positions are closed out at a loss and the counterparty fails to cover the loss. There are 2014 THOMSON REUTERS 3

September 2014 n Volume 34 n Issue 8 a number of approaches to calculating the required amount of margin, but, generally speaking, there are two starting points for determining the appropriate level of margin. Margin can be calculated-- 1. On a trade by trade or gross basis, where the amount of required margin is determined independently for each position in a counterparty s portfolio. Under this approach, the total margin that must be provided by the counterparty is equal to the sum of the amount of margin required for each individual position. 2. On a portfolio or net basis where the amount of required margin is based on the risk posed by a counterparty s portfolio across all positions. Under this approach, each individual position held by the counterparty is not considered in isolation from all other positions. There are many ways to describe what is meant by portfolio margining. The Securities Exchange Commission (SEC), in its customer margin rules relating to security futures, describes portfolio margining as follows: Portfolio margining establishes margin levels by assessing the market risk of a portfolio of positions in securities or commodities. Under a portfolio margining system, the amount of required margin is determined by analyzing the risk of each component position in a customer account (e.g., a class of options, with the same expiration date) and by recognizing any risk offsets in an overall portfolio of positions (e.g., across options and futures on the same underlying instrument). 6 When we refer to portfolio margining, like the SEC, we are primarily talking about establishing risk offsets across an aggregate portfolio of positions. Additionally, portfolio margining includes the concept of netting, where the party receiving the benefit of risk offsets grants a security interest in its portfolio to the legal entities who are its counterparties. The combination of these two elements creates a portfolio margining regime. B. How Does Portfolio Margining Work? Portfolio margining allows a clearinghouse or dealer (depending on the type of product) to call for margin commensurate with the net risk of a customer s portfolio. Margin requirements calculated on the basis of net risk are generally lower than the amounts that would be required where positions are considered in isolation of one another. This reflects the fact that many times, positions in a customer s portfolio offset or hedge against the risk of other positions in the portfolio. For example, holding a long futures position on a 10-year treasury is often a hedge against the fixed rate payments due under a 10-year interest rate swap. As interest rates change, the value of each position will move in opposite directions. Portfolio margining reflects such offsetting risks and thus allows customers to use margin more efficiently, and in totality, for margin to be more efficiently utilized across the market. Dealers also benefit from portfolio margining because measuring the risk of pairs or groups of positions which are correlated based on reference assets (e.g., options on the S&P 500 and S&P futures) or historical data provides a better methodology for evaluating the risk associated with a customer s default than would be the case were the risk associated with each customer s positions analyzed in isolation. For this reason, many swap dealers currently offer portfolio margining arrangements in uncleared OTC derivatives to their customers which allow for margin optimization. Although portfolio margining arrangements result in a reduction in overall margin held by a dealer at any time, the dealer can nevertheless maintain sufficient collateralization at all times in the event of customer default utilizing the most accurate risk methodologies. Portfolio margining arrangements typically recognize offsets among products within the same asset class but not across multiple asset classes (e.g., rates, credit, commodities, equities, and foreign exchange). However, within an asset class, different types of cash and synthetic products can and do qualify. For example, in the interest rates asset class, bonds, Treasury futures, interest rate swaps, and repos may all be subject to the same portfolio margining framework. Some commentators use the expression cross-product margining to describe these types of relationships. For purposes of this article, we use the terms portfolio margining and cross-product margining interchangeably. C. Examples of Portfolio Margining Portfolio margining arrangements exist today in a number of contexts: Among cleared derivatives (e.g., single name CDS and CDS indices) 4 2014 THOMSON REUTERS

September 2014 n Volume 34 n Issue 8 Among cleared derivatives and other cleared products (e.g., interest rate swaps and futures) Additionally, there are other potential applications between uncleared derivatives and cleared derivatives which could develop over time, although these are not presently available. As discussed below, portfolio margining has existed for decades. For example, The Options Clearing Corporation (OCC) has used portfolio margining to calculate margin levels since 1989. Regulation T of the Board of Governors of the Federal Reserve System (Reg T), which governs the amount of margin that must be maintained by customers at a brokerdealer (BD) in connection with open securities positions, was amended in 1998 to allow BDs to use exchange-approved portfolio margining programs to calculate initial and variation margin. 7 Additionally, in 2006, the New York Stock Exchange (NYSE) and the Chicago Board of Options Exchange (CBOE) amended certain exchange rules to allow margin requirements to be calculated on a portfolio basis, across a wide variety of products, including security futures and listed options. D. Markets Which Currently Utilize Portfolio Margining Reg T generally establishes initial margin requirements for securities-related credit transactions. Reg T governs the amount of margin a BD must collect from a customer in connection with purchases and sales (including short sales) of securities. Reg T does not, however, determine the amount of margin that must be maintained by a customer after the initial purchase or short sale of a security. Reg T allows securities self regulatory organizations, such as securities exchanges, to establish their own rules governing the amount of margin that must be held by BDs in connection with customer open positions. 8 Additionally, in 1998, the Federal Reserve Board (Fed) opened the way for portfolio margining by amending Reg T to exclude from its scope any financial relations between a customer and a BD that comply with a portfolio margining regime approved by the SEC. 9 The 1998 amendment allows BDs to compute initial and variation margin requirements pursuant to exchange-approved portfolio margining programs. 1. Cleared Futures and Options (SPAN) For the past 26 years, commodity exchanges in the United States, Europe, and Asia have been calculating margin requirements on a portfolio basis using the Standard Portfolio Analysis of Risk (SPAN) margin system developed by the Chicago Mercantile Exchange (CME). The introduction of SPAN completely changed the world of futures and options risk management by allowing margin requirements for futures and options on futures to be calculated on the basis of overall portfolio risk. SPAN calculates the likely loss in a portfolio of derivatives positions using a set of portfolio parameters, and sets this value as the initial margin payable by the firm holding the portfolio. 10 For example, the CME determined that there is a high correlation in the price fluctuations of the S&P 500 and the NAS- DAQ 100 futures contracts. If a customer holds offsetting positions in the two contracts, that customer will have less market risk on a net basis than if it held either position by itself. Consequently, under SPAN, the customer s net margin requirement will be less than would have been otherwise required due to the correlated positions that result in a reduction in overall market risk. SPAN is used today by 50 exchanges and clearinghouses. 11 Each exchange or clearinghouse sets its own risk parameters using SPAN. Therefore, identical futures contracts traded on more than one exchange may have different SPAN-calculated margin requirements depending on the risk parameters set by the particular exchange. However, each SPAN model generally uses options pricing models and value-at-risk (VaR) models to determine how positions will perform under different scenarios in order to assess for changes to a portfolio s price and volatility. SPAN then allows projected gains and losses for each position in a portfolio to be netted under each scenario in order to determine a portfolio-wide net gain or loss. The scenario representing the greatest potential loss is then used to determine the customer s required margin level. 2. OCC Multiple Clearing Venue Model Building on the work of the CME, the OCC introduced portfolio margining in 1989, recognizing offsetting hedged positions maintained by firms at multiple clearinghouses through the use of joint clearing accounts for the members of those clearinghouses. In the event of a default, the clearinghouses arrangement provides for the treatment of all assets and obligations associated with the joint account as well as the other clearing accounts of the defaulting member. Trades subject to cross product margining arrangements are executed on the applicable exchange for which the participating clearing organization clear trades and are then transferred to a 2014 THOMSON REUTERS 5

September 2014 n Volume 34 n Issue 8 joint account via a clearing member trade or give-up agreement. At the end of each trading day, the applicable clearinghouse transmits closing positions and settlement activity to OCC, which in turn calculates a single margin level to support the covered positions and then produces and distributes position, margin and settlement reports to clearing members. Following the 1998 Reg T amendments, OCC adopted SPAN for its portfolio margining model. 3. NYSE Portfolio Margining NYSE Rule 431, adopted in accordance with Reg T, establishes margin requirements for NYSE member firms. Rule 431 establishes initial margin requirements equal to the greater of the amount required pursuant to Reg T, Rules 400 through 406 of the Securities Exchange Act of 1934 (Exchange Act) or Rules 41.42 through 41.48 of the Commodity Exchange Act (CEA) or, if higher, the amount required by NYSE rules. Rule 431 also imposes maintenance margin requirements when the value of the positions in a customer s account falls below a specified level. Rule 431 prescribes specific margin requirements for customers based on the type of securities held in their accounts. Generally, Rule 431 requires that margin be calculated using fixed percentages, on a position-by-position basis. This approach does not fully recognize hedges or other risk offsets between different positions that may reduce the overall risk of a portfolio. In addition, the fixed margin percentages established for each position do not take into account the fact that the prices of different security positions, such as options, related to the same underlying instrument do not necessarily change equally (in percentage terms) in relation to a change in the price of the underlying instrument. In 2002, the NYSE sought approval from the SEC to modify Rule 431 and launch a pilot portfolio margining program. In 2006, the SEC approved parallel rule amendments by the NYSE and the Chicago Board of Options Exchange (CBOE) expanding their respective pilot programs permitting margin requirements to be calculated on a portfolio basis. 12 As amended, Rule 431 permits a BD to calculate customer margin requirements for eligible products including equity securities, listed options, unlisted derivatives (that is, any equity-based or equity index-based unlisted option, forward contract, or security-based swap that can be valued by a theoretical pricing model approved by the SEC) and securities futures products by grouping those products in an account that are based on the same index or issuer into a single portfolio so that offsets between positions within that portfolio can be recognized. 13 A theoretical pricing model is used to measure the potential gains and losses to each position in the portfolio under multiple pricing scenarios. Subject to a per contract minimum requirement, the margin required for each portfolio is determined by reference to the greatest theoretical loss incurred by the portfolio in aggregate after shocking the portfolio for upward and downward price movements within a defined range above and below the current market price (e.g., +/- 10%) of the instrument or, in the case of a derivative, its underlier. In the release approving the initial pilot programs, the SEC noted that the use of the methodology employed by BDs to calculate net capital haircuts for certain options and related positions for purposes of SEC Rule 15c3-1 may better align a customer s total margin requirement with the actual risk associated with the customer s positions taken as a whole, and may alleviate excessive margin calls, improve cash flows and liquidity, and reduce volatility. 14 E. Portfolio Margining and Cleared OTC Derivatives 1. ICE Clear Credit Customer Portfolio Margining As part of its efforts to more closely regulate OTC derivatives, Dodd Frank divided regulatory authority between the Commodity Futures Trading Commission (CFTC) and the SEC. 15 Under Dodd-Frank, the SEC oversees security-based swaps which are defined as swaps based on single security or loan or narrow-based index (10 or fewer securities). All other swaps, including CDS indices such as CDX and itraxx and interest rate swaps, fall under CFTC jurisdiction. What this means in practice is that, market participants are no longer able to commingle and margin their CDS indices and single-name CDS on a portfolio basis under Dodd-Frank, even if those trades are cleared at a single CCP. Due to the distinct requirements with respect to maintenance of accounts for cleared security-based swap positions regulated by the SEC and cleared swap positions regulated by the CFTC. Since this was such a departure from past practice, ICE Clear Credit petitioned the SEC and the CFTC to permit the commingling and portfolio margining of both single name and index CDS in a CFTC-regulation 4d(f) account. In the absence of relief from the SEC and CFTC, a portfolio margining program could not be estab- 6 2014 THOMSON REUTERS

September 2014 n Volume 34 n Issue 8 lished to commingle and portfolio margin cleared customer portfolios of CDS for a portfolio that includes both security-based swaps such as single name credit default swaps and swaps such as CDX and itraxx credit indices. Clients would have to post full margin on a single-name position held in an SEC account as well as full margin on an index position held in a CFTC account even if the two positions offset each other from a risk perspective. In its application to regulators ICE Clear Credit noted that by combining the positions in one account and applying ICE Clear Credit s portfolio margining methodology, the CCP provides capital efficiencies to customers while enhancing its risk management practices. In addition, by commingling in the CFTC regulated 4d(f) account, FCM customers would receive the same bankruptcy treatment and customer collateral protections under the CFTC s Legally Segregated Operationally Commingled (LSOC) regime for all cleared CDS positions, not just those regulated by the CFTC. On January 30, 2012 ICE Clear Credit received approval from the CFTC and the SEC to offer margin offsets between single names and index CDS for proprietary positions held by clearing members. However, this benefit was not extended to customers of clearing members, until, after protracted negotiation with the SEC and CFTC during 2012, ICE Clear Credit received an SEC 16 exemptive order, later confirmed by the CFTC in its own exemptive order 17. While the CFTC release was issued specifically in response to ICE Clear Credit LLC, which submitted a request to both regulators, the SEC order includes general conditions that, if satisfied by a clearing member that is both an FCM registered with the CFTC and a BD registered with the SEC, permit the clearing member to provide customers with CDS portfolio margining in a single segregated account across both index CDS and single-name CDS. These orders allowed ICE Clear Credit to provide relief for BD/FCMs that maintain clearing accounts for customer-related transactions, subject to the satisfaction of certain conditions by the BD/ FCMs themselves. The most important condition placed on the relief granted to ICE Clear Credit was a requirement that each BD/FCM obtain approval for its internal margin methodology from the SEC prior to offering portfolio margining to customers. The SEC delegated the responsibility of evaluation to FINRA, which in turn gave the BD/FCMs a set of 20 different hypothetical CDS portfolios and asked that they provide an aggregate risk margin number for each portfolio using their internal model. These results allowed FINRA to challenge the applicant BD/ FCM s assumptions about their risk management processes and work with them for a more consistent approach to managing and margining CDS and thus reducing credit risk. 18 On January 31, 2014 eight firms received approval for their internal margin models. 19 For the most part, in order to permit such portfolio margining, the approval models require that BD/FCMs require customers to post margin equal to 110% of the margin that otherwise would be required by the CCP but on an amount of risk measured on a net basis, rather than gross. Consequently, after receiving these approvals, BD/ FCMs dually registered with the CFTC and SEC can comply with certain requirements applicable to maintenance of customer accounts under the CEA without complying with parallel requirements under the Exchange Act. Put simply, these various orders and approvals allow Ice Clear Credit LLC and its clearing members to offer programs that provide for commingling and portfolio margining of cleared customer CDS. While customer clearing of single name CDS is not currently required by law, the looming possibility of punitive uncleared margin requirements and potential SEC clearing mandates may make this topic more important for customers in the near future. 20 2. CME Portfolio Margining In May 2012, the CME began offering portfolio margining of CME listed Eurodollar and Treasury futures and CME-cleared OTC interest rate swap products. 21 Full regulatory approval to offer portfolio margining to customers was granted in November 2012. Portfolio margining at CME takes account of correlations between different cleared products when calculating initial margin requirements, rather than calculating margin requirements on a product-byproduct basis. A lower net margin number can be achieved where the risk in the futures and cleared swap positions is reliably offsetting, such as when futures have been used to hedge a portfolio of interest rate swaps. To effect portfolio margining across exchange traded derivatives and cleared OTC swaps, CME created the Optimizer, a proprietary software program that is hosted on the FCM s clearing network. With certain inputs from FCMs, and relying on proprietary algorithms, the Optimizer selects futures positions that should be moved into the cleared swap account type to offset the overall initial margin requirement across a single clearing client. The tool automates the selection of futures to move and 2014 THOMSON REUTERS 7

September 2014 n Volume 34 n Issue 8 creates a transfer message that is produced and can be copied and sent to CME to make the change for the books and record at the CCP. In practice, FCMs have a small window of time to complete the Optimizer processing, clear transfer trades, and ultimately book the trades into their internal systems. CME files required for the Optimizer computation are not available until 7:30pm EST. Therefore, FCMs must create files with the trades available at this time each night. CME then calculates the portfolio margin value and provides it to clearing members. However, FCMs must develop their own operational processes to effect portfolio margining for their clients, resulting in different account structures and protocols for reporting to customers among FCMs. In some ways, the CME Optimizer was a useful test case for portfolio margining of cleared OTC derivatives. It has brought to light operational complexities, such as the difficulty an FCM faces in transferring positions for a large customer with multiple accounts into a portfolio margining account that is separate and distinct from the customer s futures account (a 4d account) or cleared swap account (a 4d(f) account). Additionally, there are practical limitations on the benefits that can be achieved since not all trading strategies lend themselves naturally to offsets, meaning that the bottom line reduction in margin may be less that the best case estimates provided by CME. 22 However, despite these limits and operational challenges, market participants agree that this type of portfolio margining creates substantial cost savings for all market participants who are eligible to participate. With nine clearing members currently participating, and over 100 accounts using portfolio margining, CME estimates that this type of interest rate swap portfolio margining has resulted in $4 billion in initial margin savings across customer and house accounts. 23 III. Policy Rationale for Encouraging Portfolio Margining As shown by the examples above, a fully functioning marketplace requires portfolio margining across both a broad set of products and legal structures. Fundamentally, the rationale for offsetting exposures through appropriate risk reduction strategies does not change whether between asset classes of swaps, between swaps and other products or between cleared and uncleared swaps. The same rationale also applies for offsetting exposure across different regulatory regimes. In other words, the availability of portfolio margining will encourage parties to use portfolio-based hedging strategies which will in turn increase market stability and reduce systemic risk. A. Reduces costs and promotes liquidity As both the historical and recent examples in Part II demonstrate, portfolio margining has been broadly accepted under various regulatory regimes and for different types of financial products. 24 Portfolio margining enables market participants to avoid posting redundant margin while ensuring that the FCM has access to sufficient margin in the event of a customer default. Therefore, a system of portfolio margining eliminates excess margin requirements without foregoing necessary protection and avoids a reduction in market liquidity resulting from the additional margin that would be required if cleared products or cleared swap types were treated separately. B. Allows capital to be deployed efficiently Portfolio margining practices minimize otherwise unnecessary increased costs of trading. Without the margin offsets available under portfolio margining, these increased trading costs are passed on to swaps end-users and thereby reduce liquidity and competitiveness in the markets as well as raise the costs of bona fide hedging in the swaps market. Furthermore, a system of portfolio margining allows capital to be invested more effectively (i.e., not tied up as redundant margin securing swaps positions) with no compromise of dealer or systemic safety. More effective investment of capital yields more profitable returns for the investing public without increasing the risk associated with entering into uncleared swaps. C. Facilitates clearing Portfolio margining of cleared OTC derivatives has eased the market transition to mandatory clearing requirements of Dodd-Frank, and should have the same result in other jurisdictions which are expected to implement their clearing requirements shortly. Because of the CFTC s phased approach to mandatory clearing (and the absence of parallel SEC rules for security-based swaps), not all liquid swaps are required to be cleared, and market participants still have significant uncleared swaps 8 2014 THOMSON REUTERS

September 2014 n Volume 34 n Issue 8 positions. Without the ability to portfolio margin between cleared and uncleared positions, a market participant will be forced to post redundant margin for its cleared positions and its uncleared positions. The availability of portfolio margining may provide economic incentives for market participants to clear their swap positions ahead of regulatory requirements in order to alleviate some of the cost of holding separate cleared and uncleared portfolios. IV. Conclusion Portfolio margining can achieve cost reduction for the users of cleared OTC derivatives, futures and equity products without any loss of systemic risk protection for BDs, FCMs and CCPs. Additionally, portfolio margining programs incentivize clearing, and avoid the liquidity drain that would result if participants were required to post excess margin to satisfy multiple, independent requirements. The work ahead for CCPs and FCMs is to expand their portfolio margining offerings wherever possible. For example, while CCPs for OTC derivatives have tended to develop as single product clearing facilities, there is a range of portfolio offsets that could be realized across products in different asset classes that are now cleared in separate CCPs. Work must be done to bridge the structural challenges caused by this separation. Potentially, as liquidity builds in cleared OTC derivatives, consideration can be given to tighter integration of clearinghouse default fund structures for different products that present risk offsets. While we have learned a great deal from the Dodd-Frank clearing mandates, the picture will become much more complete once clearing becomes implemented on a global basis, and regulators both in the U.S. and abroad adopt final rules for uncleared margin. In the meantime, market participants will need to evaluate portfolio margining offerings in place today as part of their overall collateral optimization efforts and look for new opportunities to implement portfolio margining as new regulatory requirements become effective. NOTES 1. See OTC Derivatives Market Reforms: Third Progress Report on Implementation, 15 June 2012, Financial Stability Board, available at http://www.financialstabilityboard.org/public ations/r_120615.pdf. 2. See Adaptation of Regulations to Incorporate Swaps 77 FR 66288 (November 2, 2012), available at: http://www.cftc.gov/ucm/groups/ public/@lrfederalregister/documents/file/2012-25764a.pdf. 3. See Craig Pirrong, The Economics of Central Clearing: Theory and Practice, ISDA Discussion Papers, May 23, 2011, available at: http:// www2.isda.org/functional-areas/research/discussion-papers/. 4. Another potential cost arising from the bifurcation of swaps into cleared and uncleared portfolios is the loss of the collateral netting which occurs when all swaps are held under a single ISDA Master Agreement. For example, if a market participant had bought protection on a CDS index and sold protection on the single name CDS which are components of that index, its overall margin requirement would have been reduced by virtue of the trades occurring under a single agreement, i.e. the net exposure is reduced. However, once CDS indices were required to be cleared, the same single name CDS would be left unhedged, and there would be a corresponding increase in the margin requirement for these trades with one requirement imposed by the CCP for the cleared trade, and another being imposed under the ISDA Master Agreement for the uncleared leg. 5. See CEA 4(d) (2012). 6. Exchange Act Release No. 34-46292 (July 31, 2002), 78 S.E.C. Docket 384, 2002 WL 1769439 (July 31, 2002). 7. 17 C.F.R. Section 1.20. 8. 12 C.F.R. Section 220.1(b)(2). 9. See C.F.R. Section 220.1(b)(3)(i). The Fed also encouraged the development of portfolio margining when it delegated authority to set margin requirements for security futures to the SEC and the CFTC. Letter from the Fed to James E. Newsome, Acting Chairman, CFTC, and Laura S. Unger, Acting Chairman, SEC, dated March 6, 2001. See also SEC Rule 400(c)(2)(i) (exempting from the security futures margin requirements financial relations between a customer and a security futures intermediary that comply with an appropriate portfolio margining system); CFTC Rule 41.42(c)(2) (comparable exemption). 10. How SPAN Works CME Group, http://www. cmegroup.com/clearing/risk-management/ (last visited August 27, 2014). 11. SPAN Overview CME Group, http://www. cmegroup.com/clearing/risk-management/ (last visited August 27, 2014). 12. SEC Release No. 34-54918 (Dec. 12, 2006), 71 Fed. Reg. 75790 (Dec. 18, 2006); SEC Release No. 34-54919 (Dec. 12, 2006), 71 Fed. Reg. 75781 (Dec. 18, 2006). See also NYSE Information Memo 06-86 (Dec. 21, 2006) ( IM 06-86 ); CBOE Regulatory Circular RG06-128 (Dec. 15, 2006). 2014 THOMSON REUTERS 9

September 2014 n Volume 34 n Issue 8 13. NYSE Rule 431(g) also provides: In addition, a member organization, provided that it is a Futures Commission Merchant ( FCM ) and is either a clearing member of a futures clearing organization or has an affiliate that is a clearing member of a futures clearing organization, is permitted under this section (g) to combine an eligible participant s related instruments as defined in section (g)(2)(e), with listed index options, options on exchange traded funds ( ETF ), index warrants and underlying instruments and compute a margin requirement for such combined products on a portfolio margin basis. See also FINRA Regulation Portfolio Margin Frequently Asked Questions, available at: http://www.finra.org/industry/regulation/ Guidance/P038849#products. 14. SEC Release No. 34-54918 (Dec. 12, 2006), 71 Fed. Reg. 75790 (Dec. 18, 2006). 15. See Further Definition of Swap, Security- Based Swap, and Security-Based Swap Agreement ; Mixed Swaps; Security-Based Swap Agreement Recordkeeping, 77 Fed. Reg. 48208 (Aug. 13, 2012), available at: http://www.gpo. gov/fdsys/pkg/fr-2012-08-13/pdf/2012-18003. pdf. 16. Order Granting Conditional Exemptions under the Securities Exchange Act of 1934 in connection with Portfolio Margining of Swaps and Security-Based Swaps, December 14, 2012, available at: http://www.sec.gov/rules/exorders/2012/34-68433.pdf. 17. On January 14, 2013, the CFTC issued an order permitting ICE Clear Credit and its participants to hold customer property used to margin, guarantee, or secure positions in cleared security-based swaps and cleared swaps in a Section 4d(f) account and to provide for portfolio margining of such cleared swaps and cleared security-based swaps. The CFTC s order is available at: http://www.cftc.gov/ucm/groups/public/@ newsroom/documents/file/icecreditclearordero11413.pdf. 18. Joe Rennison, FCM Models for CDS Portfolio Margin varied widely, Risk Magazine, May 1, 2014 19. Goldman, Sachs & Co., Morgan Stanley & Co. LLC, UBS Securities LLC, Barclays Capital Inc., J.P. Morgan Securities LLC, Credit Suisse Securities (USA) LLC, Citigroup Global Markets Inc., and Deutsche Bank Securities, Inc. have each received Temporary Conditional Approval Letters. See Release No 34-68433, available at: http://www.sec.gov/rules/exorders/exordersarchive/exorders2012.shtml. 20. On September 3, 2014 the Federal Reserve, Federal Deposit Insurance Corporation, Office of the Comptroller of the Currency, Farm Credit Administration, and the Federal Housing Finance Agency released re-proposed rules requiring swap dealers and major swap participants to hold margin for uncleared swaps. These rules replaced a proposal originally released by these same regulators in 2011 and are designed to conform to international norms set forth in a framework outlined by the Basel Committee on Banking Supervision and the International Organization of Securities Commission (BASEL-IOSCO). The reproposed rules are available here: http://www.federalreserve.gov/ newsevents/press/bcreg/bcreg20140903c1.pdf. 21. Introducing Portfolio Margining of Interest Rate Swaps vs. Futures, CME press release dated May 7, 2012 available at http://www.cmegroup.com/trading/otc/files/cme-irs-portfoliomargining-sell-sheet.pdf. 22. Tom Osborn, The Slow Growth of Cross-Product Margining, Risk Magazine, August 28, 2013. 23. Significant Margin Savings Cleared OTC IRS http://www.cmegroup.com/trading/interest-rates/cleared-otc/portfolio-margining-ofcleared-otc-irs-swaps-and-futures.html (last visited August 27, 2014). 24. FINRA permits portfolio margining for certain products pursuant to NASD Rule 2520(g) and NYSE Rule 431(g). OCC, CME Group and LCH. Clearnet also permit portfolio margining for certain products. 10 2014 THOMSON REUTERS