In the futures space positions are settled daily and the payment of variation margin is in the nature of a settlement payment effectively representing profit and loss on a position based upon market movement. As a result, when a futures customer makes a payment of variation margin to its FCM and the FCM (as the customer’s agent) pays that amount to the clearinghouse, the clearinghouse has in effect received a payment for its own account because that payment is in the nature of settlement. Since the clearinghouse is always flat it will inevitably take that variation margin payment and pay it out to another FCM in settlement of the offsetting position. Because the customer making the variation margin payment is making a settlement payment it has no further claim to such variation margin. The clearinghouse need not treat it as customer funds and is free to pay it out on the offsetting position. The receiving customer is free to withdraw it and treat it as its own without any equity of redemption retained by the clearinghouse or the original posting customer. This mechanism of passing variation margin through the clearinghouse is absolutely essential to the central clearing model.
Interestingly, however, in the OTC derivatives space (pre-clearing) variation margin has not been treated in the nature of settlement and the posting customer expects to get that amount back so long as it performs (at least under the NY CSA—putting aside the English title transfer approach in the interests of simplicity although even there it’s not daily settlement) because it represents property pledged to the recipient rather than a settlement payment. Of course, it is also common for the pledgee to have the right of rehypothecation of such amounts, but it is nevertheless the case that the pledgor has viewed the property pledged as continuing to belong to it. Translating this to the cleared OTC derivatives space, each clearinghouse model very much relies on the ability to pass variation margin through—because if that was not possible the model just wouldn’t work. However, that presents something of a problem vis a vis the characterization of variation margin flows for cleared OTC derivatives transactions.
If variation margin for cleared OTC derivatives is not in the nature of settlement then presumably it constitutes customer property and should be segregated and not re-used for pass through purposes. However, the CFTC in its recent final rule regarding the protection of cleared swaps customers’ property adopting the LSOC approach reaffirmed that such pass through is permissible while declining whether to take a view on whether variation margin for cleared OTC derivatives should be characterized as settlement for tax purposes. In making this reaffirmation, however, the CFTC did not articulate on what basis such pass through is permissible, which raises a number of interesting questions.
First, if variation margin is customer property (i.e. not in the nature of a settlement payment) then why doesn’t it need to be segregated i.e. on what basis is pass through being permitted? Since the CFTC doesn’t have the power to simply ignore the segregation requirements in the CEA one could theorize that this pass through of customer property, if it is customer property, must then be a permitted “investment” of customer property. However, that doesn’t track because the CFTC didn’t address it in revising its part 1.25 rules. Alternatively, if variation margin is not customer property then what could it be other than a payment in the nature of settlement? Of course, that’s not a great outcome because no one (at least that I’m aware of) really wants daily variation margin on cleared swaps to be treated as settlement generally or for tax purposes. Moreover, if variation margin on cleared swaps is not customer property and is in the nature of settlement then why pay price alignment interest on such amounts?
So, where does that leave us? To me it suggests that there are certain facts we have to accept, i.e. the necessity to pass through variation margin, but it leaves unresolved the basis on which we get there and presents a number of serious questions making variation margin in the cleared OTC derivatives space something of a conundrum. If anyone has any thoughts on how these seeming inconsistencies might be logically resolved or if you think I’ve missed something I’d be very curious to hear from you.