Section 724(c) of the Dodd-Frank Act adds new segregation requirements for both cleared and uncleared swaps to Section 4s of the Commodity Exchange Act (as added by Section 731 of the Act).With respect to uncleared swaps, these provisions state that a swap dealer or major swap participant (“MSP”) is required, upon request of a counterparty (“Counterparty”), to segregate with an independent third-party custodian any collateral posted by the counterparty that is not variation margin (i.e., initial margin or “Independent Amounts” as defined in the ISDA Credit Support Annexes). 

Independent Amount Segregation Approaches 

In March 2010 ISDA, Managed Funds Association and the Securities Industry and Financial Markets Association jointly published a white paper on Independent Amounts (the “White Paper”) describing various approaches that may be used to segregate Independent Amounts (“IA”) posted by a Counterparty for the benefit of a dealer in respect of uncleared derivative transactions. Two of these approaches contemplate the use of a third-party custodian or collateral agent (“Custodian”) based on a bilateral custodial agreement between the Dealer and a Custodian. A third approach contemplates segregating IA with a third-party Custodian pursuant to a tri-party agreement among Dealer, Counterparty and Custodian. 

Each of these approaches has various advantages and disadvantages. For example, the tri-party approach, in which the Counterparty has a direct contractual relationship with the Custodian, may be preferable for protecting Counterparty IA in U.S. uncleared derivative markets given the absence of a comprehensive customer asset protection regime and typical restrictions on transferring trades, even though the tri-party approach may be more costly and complex to administer. On the other hand, a bilateral approach to IA segregation, similar to the approach used by FCMs to segregate customer margin in the U.S. futures markets, may be preferable because it allows the Dealer to retain greater control over the IA, presents fewer technical legal issues and is administratively less burdensome to implement. In addition, the legal, credit and operational considerations associated with the tri-party approach may make it impractical and relatively costly, particularly for smaller Counterparties. A more complete description of these approaches and the pros and cons of each is contained in the White Paper. 

In light of the different approaches that could be utilized for IA segregation, the ISDA Segregated IA Working Group (the “Working Group”), comprised of firms representing both buy- side and sell-side perspectives, believes that, upon a Counterparty’s request, swap dealers and MSPs should make both the tri-party and bilateral custodial approaches available and that the IA segregation rules should allow Counterparties to choose from among the different segregation approaches that may be available today or in the future based on the cost-benefit considerations that they deem important. 

Other Rulemaking Considerations 

Implementing the segregation of IA when required by the Dodd-Frank Act will require the swap dealer/MSP and the Counterparty to address not only the segregation approach that will be used, but also several other issues that necessarily arise when collateral segregation is undertaken. Notably the parties need to agree which Custodian will be used and other commercial terms, such as fees to be paid by the Counterparty and which party will bear the risk of loss that may arise if the Custodian becomes insolvent or otherwise fails to perform. In addition, the parties need to address the form in which IA may be posted and, if cash will be posted, how and where it will be invested and held and how gains and losses on such investments will be allocated and distributed. Given the language of new Section 4s(l)(2)(B)(ii) of the Commodity Exchange Act as well as the bilateral, private nature of the trades secured by IA, the Working Group believes that the Commission’s rules should permit the swap dealer/MSP and the Counterparty to negotiate and mutually agree how to address these issues based on the facts and circumstances that are relevant to their relationship. 

We also note that Section 763 of the Dodd-Frank Act7 contains segregation provisions with respect to security-based swap agreements that are virtually identical to those applicable to swaps pursuant to Section 724 of the Act. However, the Act does not expressly require the Commission to conduct a joint rulemaking with the Securities and Exchange Commission (“SEC”) with respect to the segregation requirements. Nevertheless, we would urge the Commission and the SEC to consult closely with each other in this area so as to avoid inconsistent requirements that could introduce unnecessary costs, inefficiencies and the potential for unintended risks. More specifically, swaps and security-based swaps are both “Transactions” within the meaning of the ISDA Master Agreement and the applicable ISDA definition booklets. They are commonly transacted between two counterparties pursuant to a common ISDA Master Agreement, Credit Support Annex and ISDA definitions. As explained more fully in the White Paper, collateral requirements are usually determined, applied and satisfied between the two parties on a net basis across all types of Transactions engaged in by them. Some categories of OTC derivatives transactions may be either swaps or security-based swaps, according to the particulars of the Transaction, yet would typically be conducted by the same group infrastructure within a trading firm. There would appear to be no particular public policy advantage to be gained if segregation and custody requirements were materially different or if participants had to institute and support duplicate custodial arrangements depending on whether the Transaction were a “swap” or “security-based swap”. 

Finally, the Working Group also believes that the Commission’s rules should clarify that the notice to be provided by the swap dealer/MSP to the Counterparty pursuant to new Section 4s(l)(1)(A) of the Commodity Exchange Act need only be given once to the Counterparty and not upon the entry into every single uncleared swap.

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