It is basically understandable that with derivatives and credit derivatives in addition to counterparty risk also an issuer risk from the underlying/reference asset has to be taken into account. Here, we very much welcome the clarification that an “indirect exposure arising from those derivative contracts and credit derivative contracts for which the underlying asset does not entail a default risk of an indi-rect client shall not be considered by institutions”.
The standardised calculation methods described in Art. 6 (1) and (3) of the draft RTS to determine the exposure value with multiple underlying assets are not compatible. While in Art. 6 (3) of the draft RTS the default of the respective (“that”) issuer of the underlying asset is the determining factor, in Art. 6 (1) the default of (“any”) issuer of underlying assets is relevant. In our opinion, the same calculation method should be applied in both cases and the determining factor should be on the default of the respective (“that”) issuer. In this regard, the regulation in Art. 6 (1) should be aligned with the word-ing of Art. 6 (3).
Options are – as far as is known, for reasons of hedging asset positions and in case of network-structured groups as part of brokering client business to the central institutions* – held in the non-trading book too. What is more, options can be part of a fund that is in turn held in the non-trading book. This does not give rise to problems for calculating the indirect exposure values.
*In these cases, for reporting purposes, the house bank represents the chain: client – house bank – central institution
It is understandable that using credit derivatives to hedge and, if the protection buyer has already taken this into account as a recognised credit risk mitigation technique (CRMT) in conformity with Art 399 CRR, the indirect exposure value according to Art. 4 (3) of the draft RTS will in these cases be set at zero. We would like to point out here that for this statement the wording in the explanatory text does not fit “On the contrary, when the credit derivative contract is assigned to the trading book or the non-trading book and is not considered as an eligible credit risk mitigation technique for large exposures purposes, as prescribed in Article 399, institutions have to reduce the indirect exposure toward the reference name by the value of the credit protection and have to add the positive value of the indirect exposure to its exposure toward the protection buyer”. As we understand it, the last clause describes precisely the procedure in the event that a credit derivative is applied by the protec-tion buyer as a CRMT (substitution for protection seller). We assume that instead of “protection buy-er”, it should then read “protection seller” and request clarification accordingly (see answer to Q 8).
Furthermore, if the institution is the protection seller, the methodology is not risk-adequate.
Indirect exposure value in the non-trading and trading book =
market value of the credit derivative (x) + amount to be paid to counterparty in case of default by the issuer of the underlying instrument (nominal value of derivative) – amount to be received from coun-terparty in case of default by the issuer of the underlying asset (0) = Nominal value of derivative + market value of the credit derivative x.
The more the credit derivative is, from the protection seller’s perspective, in the money, the higher the market value x and the higher the exposure value. Economically, this does not make sense be-cause the payment by the protection seller will be increasingly unlikely. The exposure value should be limited to the nominal value of the derivative, so that the derivative’s negative market values properly reduce the exposure, but derivative’s positive market values are not additionally factored in because they overstate the risk.
We do not follow why the nominal value of the credit derivative – for derivatives in the trading /non-trading book, provided no CRMT is applied – is taken into account as an indirect exposure towards the protection buyer (see Explanatory Text for draft RTS, p. 21). The nominal value of the credit derivative (= amount to be paid in case of a credit event) would have to be taken into account as an indirect exposure by the protection seller against the underlying. We request clarification (see also answer to Q 7).
Based on our interpretation and the background and rationale in para. 34, Art. 5 (2) of the draft RTS should for the sake of clarity be worded as follows:
For those transaction legs entailing default risk of the issuer of the underlying asset, institutions shall calculate their indirect exposure value as if they were positions in those legs.
With reference to Art. 3 CRR, it is basically always possible for institutions to recognise more con-servative amounts against the large exposure limits than would otherwise be necessary under the respective regulation. In this respect, the explicit inclusion of a fallback provision would be dispensa-ble but could for the sake of clarification be conducive to understanding.
The basic interaction between the original look-through requirements according to Art. 390 (7) CRR in conjunction with the Delegated Regulation (EU) No. 1187/2014 and the RTS under consultation is open. According to Art. 390 (7) CRR, also “other transactions where there is an exposure to underly-ing assets” fall under the look-through requirements for the large exposures regime. In line with long-standing supervisory and institutions’ practice in Germany, included hereunder, for example, are credit derivatives which refer to multiple reference assets, particularly credit default swaps (CDS) and credit linked notes (CLN), or derivatives on indices. The risk from underlying assets is thus already taken appropriately into account for limiting large exposures. It should be clarified that in these cases the RTS does not apply.
While the wording in Art. 6 (1) and (2) of the draft RTS refers expressly only to (credit) derivatives with an index or fund as an underlying asset, the tenor in the questions on Art. 6 (Q 11 and 12) and para. 39 “Background and rationale“ is more general in terms of multiple underlying reference names in the form of a structure. We consider this too to be appropriate. In this regard, the wording in Art. 6 (1) and (2) of the draft RTS should be amended accordingly and the scope of application of EU Regulation No. 1187/2014 for assigning indirect exposure to a client extended more generally to structures un-derlying (credit) derivatives.
Following on from Art. 6 (4) of the Delegated Regulation (EU) No. 1187/2014 regarding the look-through, we propose that a monthly simulation on the level of the individual underlying reference names should be sufficient. Even with a monthly simulation, moreover, the current state of the anal-yses cannot conclusively verify whether such a simulation including all kinds of underlying assets is even technically possible. This applies particularly to indices such as the MSCI World with more than 1,600 underlying reference assets.
According to “Background und rationale” para. 39, Art. 6 (3) of the draft RTS should be applied also to “embedded derivatives”: “This article would include also the case of embedded derivatives”. We un-derstand this as a (renewed) clarifying wording of para. 14 on the basic scope of application of the RTS. Art. 6 (3) of the draft RTS applies to embedded derivatives only if the embedded derivative is based on multiple underlying reference names that do not constitute a structure.