Outside Publication

Portfolio Margining of Cleared Credit Default Swaps, Journal of Investment Compliance

July 2013

This article, DOI 10.1108/JOIC-04-2013-0012, is (c) Emerald Group Publishing and permission has been granted for this version to appear on MorganLewis.com. Emerald does not grant permission for this article to be further copied/distributed or hosted elsewhere without the express permission from Emerald Group Publishing Limited.

Prior to the adoption of the Dodd-Frank Act, market participants routinely traded swaps — such as credit default swaps ("CDS") — bilaterally and held the resulting swap positions and the associated collateral supporting such swaps on a commingled basis in a single account at a financial intermediary. Holding all types of swaps in a single account (and in particular, economically correlated swaps and related collateral) is efficient from a capital allocation and portfolio management perspective. For a customer trading in multiple types of assets and holding a portfolio of assets with a single counterparty, some of the these swaps may naturally offset, or hedge, the risk of other assets within the same portfolio, so that the net risk of the portfolio is significantly less than the risk of each position measured separately.

By requiring that most standardized swaps be centrally cleared, Congress called for a significant change in the market structure and risk management of swaps. Under the bifurcated approach taken by the Dodd-Frank Act with respect to the jurisdiction and regulation of swaps in the United States, broad-based indices of credit default swaps ("index CDS") are defined as "swaps" subject to the jurisdiction of the Commodity Futures Trading Commission ("CFTC"), while single-name CDS are defined as "security-based swaps" subject to the jurisdiction of the Securities and Exchange Commission ("SEC"). The CFTC and SEC maintain different, yet parallel, regulatory regimes relating to the clearing, margining and customer protection requirements for swaps and security-based swaps. Once the mandatory clearing requirements for swaps and security-based swaps become effective, market participants will no longer be able to effectively hold and margin single-name CDS and index CDS in a single account on a portfolio basis. If the margin on each index CDS and single-name CDS were required to be calculated independently, the result would be a margin requirement significantly in excess of what would be required to address the market risk related to the aggregate portfolio of CDS positions. Portfolio margining presents a solution to this problem, in which the margin requirement for each customer is calculated based on the actual net risk of a customer's portfolio. This article highlights the regulatory relief provided by the SEC and the CFTC to permit for the commingling and portfolio margining of cleared index CDS and single-name CDS in a customer account.

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