From Chaos to Clarity | The Journey of CDS Portfolio Margining Regulation


OTC Clearing is the most complex business that I have been involved with in over 10 years in the Financial Services Industry. Complex due to the uncharted terrain of rules, regulations, their interpretations, sheer number of market participants, Technology and operational systems and processes. Safe to say that Clearing has the maximum number of touch points than any other financial transaction. Not everyone can stomach the continued chaos and pace of change. Some of us thrive on it though! This is my attempt to shift from Chaos to Clarity in the OTC Clearing Space. First stop is CDS Portfolio Margining and how the landscape evolved in the last few years. 

Year 2009 through 2011 – Dodd Frank Act and the Bifurcated Regulatory Framework:
The Dodd Frank Act divided the regulatory authority of Swaps between the CFTC and the SEC. The SEC was expected to provide oversight over “security-based swaps” which are defined as swaps based on single security or loan or narrow–based group or index of securities. All other swaps which includes Credit default swaps & index trades fell under the CFTC jurisdiction. This translated to indices being cleared through an FCM or registered DCO under CFTC rules and single name trades through broker-dealer or SEC registered clearing agencies and that clients are subjected to different customer protection and broker insolvency regimes. 

Typically, market participants would like to evaluate a portfolio in its entirety while engaging in CDS transactions. The bifurcated regulatory regime would make it impossible for a customer to efficiently trade and maintain a portfolio of cleared Index CDSs and single-name CDSs in the absence of portfolio margining. However, there was a way out. These two agencies were also granted the ability to issue relief to alleviate inefficiencies created by the two different sets of regulatory requirements!

Recognizing that prior to the implementation of the Dodd-Frank Act, market participants effectively were able to commingle and margin their Index CDSs and single-name CDSs efficiently on a portfolio basis with their bilateral swap counterparties, and desiring to preserve the operational and capital efficiency of such commingled positions, as well as to facilitate the transition to central clearing and alleviate the operational and capital issues raised by the different customer protection and insolvency regimes, ICE Clear Credit and ICE Clear Europe (both registered as derivatives clearing organizations and clearing agencies) petitioned the SEC and the CFTC to permit the commingling and portfolio margining of CDS assets in a CFTC-regulated account.

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, absent relief for client clearing, this benefit could not be extended to buy-side clients. Client positions in swaps or security based swaps were expected to be held in separate account classes regulated independently by the CFTC or the SEC. Also they continued to be subject to different bankruptcy regimes. The CFTC account class would be governed by Part 190 and the SEC account class would fall under Securities Investor Protection Corporation Trustee and could potentially be liquidated at different times. 

ICE Clear credit awaited a response on their petition to the SEC and CFTC (made in October 2011). There was widespread concern in the market that delayed relief to provide margin efficiency will diminish liquidity in the market. The market wanted to preserve the operational and capital efficiency from the bilateral world. Additionally, mandatory clearing of CDS was on the horizon. This could potentially hinder the goal of moving CDS markets to clearing.

"The ability to margin accounts on a consolidated portfolio basis is necessary to encourage increased clearing, reduce systemic risk during times of stress, and provide capital efficiencies for market participants," said ICE Clear Credit President Christopher Edmonds. Click here for the ICE press release

December 14, 2012: 
Finally, the SEC published an exemption order on December 14, 2012 that essentially gave FCMs the ability to commingle and portfolio margin the customer positions in cleared CDS contracts in a single segregated account extending the benefits of cross-margining to buy-side firms. This was novel because it permitted portfolio margining at the client level for the first time and also allowed their related margin to be pooled into one account instead of two separate commodity and security accounts. However, there was a catch. A number of conditions were added – the most important one being that FCMs obtain approval for their margin methodology from the SEC prior to offering client portfolio margining. Perhaps a very prudent step from regulators point of view but nevertheless one more additional step in the process.

As expected, this generated lot of discussion in the market. One camp argued that the CCP methodology was already approved by regulators and FCMs were expected to collect at least the CCP margin from the clients so why this additional burden?

February 2013:
The SEC started having discussions with various FCMs on their methodology however, no models were approved by the SEC yet and the clock started ticking for the date of March 11 for mandatory clearing of index CDSs. Buy-side firms faced the prospect of losing margin offsets which were available to them in the bilateral world since indexes would be forced into a clearing house while single names would remain outside and both would be margined separately. Even if an FCM opted to clear single name CDS trades, an FCM would be prevented from margining the trades on a net basis. FCMs, CCPs and clients alike were hoping to get some reprieve from the SEC in advance of the mandatory clearing dates.

March 8, 2013:
The SEC issued a last minute fix - temporary approval to address the buy-side issue in advance of March 11 mandatory clearing date. FCMs could cross-margin index and single name CDS for clients but only if the FCM charged 150% of the margin required by CCP for clients with virtually no credit risk. For all other clients, 200% of the initial margin requirement of the CCPs should be collected on positions held in the portfolio margin account. Most clients would fall in the second bucket. The SEC also allowed FCMs to charge 100% of the ICE Credit margin if they take a 100% capital charge of the difference in the margin amount between their number and the applicable higher multiplier. How could FCMs absorb this cost? It would be passed down to clients. These SEC terms were not similar to those available for dealer portfolio margining and there was a lot of angry reaction from buy-side firms. 

ICE Clear Credit decided not to offer single name clearing for clients of its member firms due to these punitive margin requirements. There was no appetite for clearing single name CDS as a result.  Was SEC thwarting one of the key aims of Dodd Frank – promote client clearing?

April 15, 2013:
The SEC asked ICE Clear Credit to re-start offering clearing of single name CDSs. The SEC interpreted ICE’s rules (Rule 309g) as requiring it to accept single-name trades for clearing, and said that if it insists on not clearing, then it would have to submit a rule change. So ICE planned to go ahead and clear all client-traded single names submitted starting April 15th.

June 7, 2013:
A backlash to the stop gap measure announced in March pushed the SEC to change the rule which would stay in place for the next six months until December 2013. Under this approach, FCMs could offer portfolio margining to clients as long as they agree to collect at least the level calculated by the CCP plus additional margin required by the CFTC and any margin arising from risk management procedures. This translated to an effective 110% minimum level with 10% coming from the CFTC rules for customer trades at CCPs. So, buy side firms had to post 110% of the margin that a CCP would collect from its members.  No margin models were approved by SEC yet.

August 2013:
Single name clearing volume was not picking up primarily due to the fear of the unknown. No one knew whether these temporary rules will be extended post December or they would be reset to two times margin requirement once again. The biggest US CDS clearer, ICE Clear Credit, had so far handled just $60 million in single-name CDSs from the buy side, compared to roughly $2 trillion in client index trades. Obviously, this was applicable only to those clients who benefited from portfolio margining. There was a huge section of the buy-side population which had directional single name CDS positions who opted to remain uncleared since bilateral world offered them better margin savings.

Dec 7, 2013:
The SEC extended their temporary ruling of portfolio margining for index and single name CDS by posting 110% of the CCP margin until Jan 31, 2014. There was some disappointment. Most participants wanted to see a final regulation in place instead of temporary extension.

January 31, 2014:
The first eight banks received approval for their internal margin model! For this evaluation, FCMs were given the same set of 20 different hypothetical CDS portfolios and asked that they provide an aggregate risk margin number for each portfolio to FINRA as calculated by each firm’s internal model. The results allowed FINRA to challenge the firm’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. After these approvals, most FCMs internal methodologies continue to produce 110% of CCP margin. This was a welcome step in the long-winded journey though not the end yet.

FINRA 4240 and SEC Portfolio Margining Rule:

FINRA has established an interim pilot program with respect to margin requirements for any transactions in CDS held in an account at a member. This program will automatically expire on July 17, 2015.

Part (c)(1) and (c) (2) of this rule specify that clearing members should use margin methodology that has been approved by FINRA as specified in the Regulatory Notice. Members shall also, based on the risk monitoring procedures and guidelines in para (d) of this rule determine, whether applicable requirements are adequate with respect to margin. For clearing members that do not have their margin methodology approved by FINRA, they should use the applicable margin methodology set forth in supplementary material of this rule.

However, Part (c)(3) specifies that in lieu of the above paragaraphs, with respect to CDS held in an account subject to an approved portfolio margining program,a member may require to hold the amount of margin determined by the member’s portfolio margin methodology and that the member should notify FINRA in advance in writing of its intent to operate under the portfolio margin program.

So this effectively suggests that FCMs have to abide by 4240 rule if they do not avail of portfolio margining program under SEC.

Click here for the FINRA 4240 rule details.

2014 and Beyond:
There is more clarity than ever before in the portfolio margining space for CDS. However a number of questions still need to be answered:

  1. How do you treat the portfolio when a client clears single name on more than one CCP?
  2. Do you include excess margin posted by the client in other asset classes in your calculations?
  3. What happens if clients exit their position in index trades, leaving only single name trades in the segregated 4df account? Does FINRA 4240 rule apply to such index trades? See box above for details on FINRA 4240 Rule.

The Journey long..

Disclaimer: The views expressed in this blog are mine only, and don’t represent those of any employer, past or present with whom I have worked.