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Federal Register / Vol. 86, No. 2 / Tuesday, January 5, 2021 / Rules and Regulations netting of all transactions under a single ISDA Master Agreement impossible.123
As a result, the implementation of the hedging limitation would be extremely complex and result in potentially added operational risk, and certain swap entity counterparties, given the added market and bankruptcy risk, may shy away from undertaking swaps with CSEs that rely on the alternative method of calculation of IM.124
A commenter also pointed out that having to use the table-based method of calculation for determining IM in some circumstances and a counterpartys IM
model in other circumstances would be operationally complex for a CSE, potentially to the point of being unworkable, and may result in the CSE
being forced to choose between entering into transactions in the inter-dealer market or using the alternative method of calculation.125 The commenter further stated that the hedging limitation could have negative implications for liquidity in certain markets, as some CSEs with unique insights and risk profiles that are best situated to assume customer risk from other SDs may opt not to trade with such SDs to avoid the burden associated with the hedging limitation.126 Another commenter stated that costs associated with the hedging limitation, including operational and documentation burdens, could lead small CSEs to cease providing risk mitigation services to end-user counterparties, leaving endusers with unhedged risks.127
The concerns raised in the foregoing comments hinge on two ideas: i CSEs undertake hedging and speculative swaps with swap entity counterparties;
and ii there is no clear standard for determining which swaps are entered into for hedging purposes. Commenters assert that because CSEs undertake both hedging and speculative swaps with swap entity counterparties, the implementation of the hedging limitation would add further complexity to the transactions and would be burdensome as swaps are generally managed on a portfolio basis and may be under a single master netting agreement or credit support annex, making the separation of hedging and non-hedging transactions challenging, if not impossible.128
In response to these concerns, the Commission acknowledges the potential jbell on DSKJLSW7X2PROD with RULES

123 Id.
124 See Associations 10/22/20 Letter at 4; BPEC
10/23/2020 Letter at 6; FIA 10/22/2020 Letter at 8.
125 Working Group 10/22/2020 Letter at 4.
126 Id. See also STRM 10/23/2020 Letter at 5.
127 FIA 10/22/2020 Letter at 8.
128 See BPEC 10/23/20 Letter at 6; FIA 10/22/2020
Letter at 8.

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burdens associated with the implementation of the hedging limitation. However, the Commission points out that the proposed addition of a method of calculation of IM that would enable a CSE to rely on a swap entity counterpartys model calculation of IM provides an alternative to the two existing methods of calculation of IM.
The alternative method provides flexibility to address a particular situation illustrated in Letter 1929. As such, it is intended for use by CSEs whose core swaps business is with nonswap entities but that occasionally enter into swaps with a few swap entity counterparties to offset the risk of customer-facing swaps. Given the limited swaps business with swap entity counterparties, it is uneconomical for the CSEs to develop, adopt, and maintain a proprietary risk-based model for the sole purpose of engaging such counterparties.
In light of the intended use for the alternative method of IM calculation, the Commission incorporated in the Proposal, in line with Letter 1929, the hedging limitation restricting the application of the proposed alternative method of IM calculation to uncleared swaps entered into by a CSE to hedge the CSEs customer-facing risk. The Commission noted in the Proposal that the incorporation of the hedging limitation would also have the effect of limiting the use of the proposed method of IM calculation. While the proposed alternative method of IM calculation was intended to make the alternative method set forth in Letter 1929 more widely available, the Commission stated that its application raised some concerns that would be mitigated, in part, by limiting the use of the alternative method of calculation to hedging transactions. More specifically, the Commission expressed the concern that in calculating the amount of IM to be used by the CSE to determine the amount to be collected from the swap entity counterparty, the swap entity counterparty could miscalculate the amount of IM or may be motivated to underestimate the amount of IM in order to post lesser IM amounts to the CSE. In turn, the CSE, without a proprietary model to calculate IM, would have no meaningful way to verify whether the amounts generated by the swap entity counterparty were correct or to contest the amounts, potentially resulting in the CSE collecting insufficient amounts of margin to mitigate the risk of its swaps.
The Commission notes that there are other safeguards in the Commissions regulations, such as risk management requirements applicable to both CSEs
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and their swap entity counterparties, that could address the potential miscalculation or underestimation of IM; however, the Commission believes that these safeguards do not obviate the need for the hedging limitation. Rather, in the Commissions view, the hedging limitation will work together with such other measures to provide effective protections to address the concerns raised by the application of the alternative method of calculation of IM.
Accordingly, the Commission has decided to retain the hedging limitation.
The Commission expects that counterparties that engage in both hedging and speculative transactions would engage in such a small number of speculative transactions that the complexity and burden of separating speculative and hedging transactions and operationally implementing the hedging limitation would be rather low.
On the other hand, if the speculative activity between the CSE and the swap entity counterparty is so robust as to complicate the use of the alternative method of calculation, the CSE should be able to carry out its own calculation of IM by either adopting a proprietary model for the calculation of margin or using the table-based method of calculation. It follows that if the CSE
adopts a proprietary model of calculation for its speculative swaps, the CSE should be likewise able to adopt a model or use the same model for calculating IM for its hedging swaps, thus obviating the need to rely on its counterpartys IM calculation.
Regarding comments asserting a lack of a clear standard to differentiate between hedging and non-hedging swaps, the Commission believes that the existing standard set out in section 4ac2B of the CEA 129 to define bona fide hedging transaction or position provides a suitable framework for determining which swaps are hedges for the purpose of applying the alternative method of calculation. By referring to section 4ac2B for this purpose, the Commission is setting forth a principles-based approach, not requiring strict adherence to all the terms of the statute, as the statute addresses physical markets and products not pertinent in this context, and pertains to issues i.e., speculation in the physical markets outside the scope of this Final Rule. Key principles derived from section 4ac2B that should be taken into account in determining whether a swap between a CSE and a swap entity counterparty has been entered into for hedging purposes include: a Whether the swap reduces 129 7

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U.S.C. 6ac2.

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