Phase 5 mitigation mitigated

Trailing in the wake of their northern neighbours, the CFTC has today issued a Staff Advisory confirming that there is no requirement for covered swap entities (CSEs) to put IM documentation and custody arrangements in place before the $50m threshold is reached.  As the conclusion to the Advisory notes:

“Accordingly, to the extent the $50 million IM threshold is not exceeded, there are no applicable IM requirements, and no need for any pertinent documentation or custodial arrangements.”

In isolation, a model of clarity – no breach, no docs. However, the Advisory makes it explicit that this is only the letter of the law:

“This advisory clarifies that while no specific IM documentation is required prior to reaching the $50 million IM threshold, DSIO expects that CSEs will take appropriate steps to have the required IM documentation upon reaching the IM threshold” (DRS emboldening).”

“Commission regulation 23.504 directs CSEs to take appropriate steps to ensure the timely execution of IM documentation required by the CFTC Margin Rule, such that a CSE must complete the documentation by the time it reaches the $50 million IM threshold.”

“CSEs must therefore have an appropriate risk management system to calculate and monitor IM amounts and must act diligently as such amounts approach the $50 million IM threshold, so that they can ensure compliance with the IM requirements and have all required IM documentation in place once IM amounts reach such level.” (emboldening in all quotes by DRS)

The Guidance is entirely in line with the BCBS\IOSCO 2019 statement and its Canadian OSFI echo; if anything, the repetition quoted above places greater emphasis on the need to have all IM arrangements in place before the threshold is breached. Purely legally, they could instantiate all IM arrangements contemporaneously with crossing of the threshold; practically, negotiations and custody account setup will have to be commenced months in advance of an anticipated breach.

The Guidance achieves the legerdemain of answering a number of questions, while finally shedding little light. Market participants may now be predisposed to assume the following:

• Outgoing (in the imminently standing-down sense) CFTC Giancarlo’s epistolary “recommendation” that IM arrangements may be put in place following a breach has been decisively rejected – there will be no “grace” period
• The BCBS\IOSCO, OSFI, CFTC formulation will be adopted by other major regulators
• More specific guidance on this mitigation strand is unlikely
• Further mitigation kites e.g. increasing the threshold – are increasingly unlikely

If not exactly elephants, the phase 5 regulatory room is still packed with pachyderms:

• What does “approach” mean? Market participants can assess the growth in their notional vs. the likely time to put arrangements in place. They cannot account for market volatility which may suddenly disrupt their “diligence”.
• Can IM exposure be effectively and accurately monitored without the full detail and legal certainty assured by having complete IM documentation in place?
• While falling short of actual margin exchange, the calculation and monitoring of IM amounts will be resource-intensive. Is it easier to pre-empt the uncertainty, benefit from the creditor protection conferred by IM and put arrangements in place irrespective of imminence to breach?

The BCBS\IOSCO statement raised more questions than it answered. Although it took some time to respond, the CFTC is the first of the major regulators to clarify its position. It might be argued that this is the clarity of a clearly perceived fog.

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