On 23 July 2020 the EBA has published a consultation paper on the treatment of indirect exposures arising from derivatives and credit derivatives in the large exposure regime (Draft Regulatory Technical Standards on the determination of indirect exposures to underlying clients of derivatives and credit default derivatives under Article 390(9) CRR2 (EBA/CP/2020/14)). The publication marks the next important milestone in specifying the new provision entailed in Art. 390(5) CRR2 which will enter into force in July 2021. This new CRR2 provision already requires institutions to take into account those risks towards the issuer of an underlying reference asset that it has entered into only indirectly by closing a derivative (e.g. option, forward) or credit derivative (e.g. CDS) contract. The accompanying EBA standard is now intended to define a concrete methodology specifying the determination of such indirect exposures. Based on the present consultation paper it is to be expected that implementing the methodology proposed will entail various challenges both from a technical as well as an operational perspective.
Typically, a derivative contract results in counterparty credit risks that an institution has to allocate to the counterparty of the respective derivative contract both for the purposes of determining own funds requirements as well as when monitoring large exposure limits. Insofar as one or more reference debtors or issuers (“reference clients”) are underlying the derivative, the default of the reference client(s) might constitute an additional source of risk for the institution. This holds true, for example, in case of a short put option or a future contract on an equity or debt instrument. In both cases the default of the underlying reference client results in a deterioration of the value of the underlying reference instrument. The same holds true for the seller of a credit derivative who, featuring as a protection seller in this scenario, thus exposes himself/herself to the credit risk of the underlying reference debtor. Against this backdrop Art. 390(5) CRR2 stipulates that potential indirect risks arising from derivative and credit derivative contracts are to be identified, determined and allocated to the respective reference names for purposes of reporting and monitoring large exposures.
The contents of the EBA consultation paper in a nutshell
With its consultation paper EBA takes up this basic provision of CRR2 and specifies the methods to be applied when determining and calculating the indirect exposures arising from derivatives and credit derivatives. The methods proposed are intended to be applied both in the banking book and trading book alike. EBA basically differentiates between (credit)derivatives with a single underlying reference name and (credit)derivatives with multiple underlying reference names. Common to all the methodological stipulations proposed by EBA, however, is the following fundamental concept: a positive indirect exposure can only arise if the institution incurs a loss in the event of a default of the underlying reference name (i.e. in a “long call”- as well as in a “short put”-scenario). In all other cases (i.e. in a “short call”- or a “long put”-scenario) the indirect exposure arising from a (credit)derivative is negative. Negative indirect exposures are relevant in the large exposure regime only insofar as they constitute netting potential, i.e. they might be used for netting purposes within the trading book (cf. Art. 390(4) CRR).
(Credit) derivatives with a single underlying reference name
For purposes of identifying, determining and calculating indirect exposures arising from (credit)derivatives with a single underlying reference name EBA distinguishes three distinct categories of derivative contracts:
- Credit derivative contracts (e.g. CDS, TRS)
- Other derivatives (e.g. Swaps, Forward)
With respect to options naturally the design and structuring of the options contract (call vs. put) as well as the perspective of the reporting institution (long vs. short) are to be taken into account in a next step. The indirect risks arising from a long call option are to be quantified as the amount of the current (positive) market value of the option. The rationale behind this lies in the assumption that, even though in the event of a sudden default of the underlying reference name (“jump to default”) the option would not be exercised, the market value of the option would gravitate towards zero, thus resulting in a (valuation) loss for the reporting institution in the amount of the current market value. In case of a short put option the event of a default of the underlying reference name would result in the option being “in the money” and consequently being exercised, leaving the reporting institution obligated to pay the agreed upon strike price. Accordingly, the indirect exposure value in case of a short put option is to be calculated as the amount of the strike price adjusted by the amount of the current market value of the option.
Indirect exposures arising from credit derivative contracts are to be calculated consistently as the amount of the current market value of the credit derivative adjusted by the amount that the reporting institution will have to pay (protection seller) or will receive (protection buyer) in the event of a default of the underlying reference name. In case the institution acting as protection buyer has already recognized the credit derivative within the scope of its credit risk mitigation techniques (substitution approach), the indirect exposure value is to be set to zero.
For the remaining cluster of other derivatives, as a fundamental rule, each contract is to be decomposed into individual transaction legs. A forward contract on a stock, for example, can be decomposed into a cash-leg (paying the purchase price) and a stock-leg (receiving the stock). In this example, the reporting institution has to consider the long-position held in the stock-leg as the relevant indirect exposure. In case a decomposition of a derivative contract is not possible, the indirect exposure value is to be calculated as the maximum loss that the reporting institution could incur following the default of the underlying reference name (fallback approach).
(Credit) derivatives with multiple underlying reference names
With respect to (credit) derivatives with multiple underlying reference names (e.g. CIUs, indices, baskets of various debt or equity instruments) the EBA basically proposes a uniform calculation methodology. The only distinction is made between instruments for which a look through of the underlying components is possible, or even has to be performed, and instruments for which no look-through-approach is applied.
In case a look-through-approach is applied, for each underlying reference name an individual indirect exposure value needs to be calculated. This individual indirect exposure value is to be quantified as the variation in the price of the (credit)derivative assuming the default of the respective underlying reference name. In case of an index composed in total of e.g. 30 underlying reference names, thus 30 separate simulations of default are to be carried out in order to determine the respective indirect exposure values.
In case a look through is not possible, or performing a look through would be unduly burdensome, institutions may apply a fallback approach. This fallback approach requires an institution to simulate the event of a simultaneous default of all underlying reference names. The variation in the price of the (credit)derivative resulting from such a combined default event is to be considered as the indirect exposure value towards the “structure” and allocated pursuant to the provisions of Commission Delegated Regulation (EU) No 1187/2014: only if the indirect exposure value of the “structure” is below or equal to 0.25% of the institution’s Tier 1 capital, it may be assigned to a “separate client”; otherwise the indirect exposure has to be added to the exposure towards the “unknown client”.
Challenges and next steps
The fact that (credit)derivative contracts might entail indirect risks towards possible underlying reference names is not an entirely new insight. At least as far as institutions in Germany are concerned it is well-established practice for institutions to account for such indirect exposures in their respective reporting systems. Hence, the new provisions laid down in the CRR2 and the consulted EBA standards seem to be intended first and foremost to harmonize the treatment of indirect risks within the EU. However, our analyses have pointed out in particular the following challenges:
- The provisions proposed by EBA do not differentiate between positions held in the banking book or trading book. What is more, the provisions are intended to apply only in the realm of the large exposure framework. The up to now common recourse to the (issuer-related) net long position in the trading book, calculated principally for purposes of the market risk framework, does not seem to be viable any longer. Instead a separate computation solely for purposes of the large exposure regime will be necessary.
- The proposed methodology for determining indirect risk exposures arising from (credit)derivatives with multiple underlying reference names requires a calculation of simulated defaults or a sensitivity analysis that still needs to be defined in more detail and that typically is not easily available within common regulatory systems and practices.
- The methodology proposed by EBA is intended to apply to embedded derivatives as well. However, the present consultation paper does not contain further elaborations with respect to either the definition of what constitutes an embedded derivative or the issue of adequately decomposing an embedded derivative (e.g. convertible bond). Overall it is to be noted that the high degree of complexity of various implementation issues can only be managed in close cooperation with product experts.
- Given that in its methodology EBA overall emphasizes the possible (valuation) loss of market values in the event of default of the underlying reference name(s), there is also a potential for significant quantitative effects in comparison with the approaches and methodologies currently applied by institutions.
- Considering that the methodology proposed is purely regulatory in nature even more differences (in need of explanation) between the market or risk management perspective, on the one hand, and the reporting, monitoring and resolution of large exposures, on the other, will emerge.
The consultation paper thus entails a lot more than simple changes in the details. By all means institutions should therefore analyze early on the individual effects of the EBA proposals, and, wherever relevant, also participate in the ongoing consultation process (open until 23 October 2020) by bringing in their individual findings from such analyses. Such an initial gap and portfolio analysis combined with a data availability check as well as a first gathering of the relevant bank departments might at the same time provide the necessary headroom for implementing the final rules targeted and efficiently by July 2021.
Please feel free to contact us at any time if you have questions regarding the EBA paper or if you need support with your further investigations. We have put together a team comprised of various experts on large exposures and market risk as well as product experts that will provide you with holistic responses to your implementation issues.
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