According to Article 111(6) and (7) of Regulation (EU) 575/2013 (hereafter referred to as ‘CRR’), the exposure towards credit institutions in the form of derivative contracts for the purpose of counterparty credit risk capital requirements shall be determined net of cash collateral received, in line with the provisions set forth in Chapter 4 and Chapter 6 of the CRR.

Collateral received by the covered bond issuer has the purpose of mitigating the exposure to the derivative transaction’s counterparty. Cash collateralisation has the effect of increasing the credit (or – equivalently – decreasing the debit) of the issuer’s general operating account with the central bank. As such, being indistinguishable within the issuer’s estate, it cannot be segregated for the benefit of the covered bond programme (e.g. by way of annotating the amount of cash collateral received with the cover register entry of the associated derivative transaction). 

Conversely, the collateral received constitutes a latent obligation of the issuer/covered bond estate to return it to the counterparty/collateral provider upon a revaluation of the derivative transaction’s netting set no longer requiring variation margining to that extent, thus constituting a latent coverable obligation according to point c in Article 15 paragraph 3 sub-paragraph 1 of Directive (EU) 2019/2162 (hereafter referred to as ‘CBD’). A covered bond estate’s inability to honour this redemption obligation, which is theoretically due at any time, would constitute a breach of contract or a failure-to-pay under standard governing documentation resulting in early termination of the derivative transaction, in line with point d of Article 11 paragraph 1 CBD, thereby preventing the continuation of the derivative transaction, required by point d of Article 11 paragraph 1 CBD, just as it may become relevant for covered bond investor protection due to the transitioning from first to second recourse.

Therefore, for cash collateral to be taken into account when determining the extent to which a cash-collateralised derivative transaction within the meaning of Article 11 CBD  counts as an exposure to the counterparty credit institution and, thus, utilises the corresponding CQS-linked limits as required by Article 129 paragraph 1a CRR, it needs to be fully segregated for the benefit of the covered bond programme, cf. Article 12 paragraph 1 sub-paragraph 2 CBD. This requirement implies the following conditions shall be met:

• there is a legally valid and enforceable agreement that the received collateral may be used to offset amounts due to the covered bond issuer upon involuntary early termination (“breach of contract”) of the derivative (for instance, because of clauses of netting-by-novation of close-out amounts in ISDA Master Agreement), as per Article 30(1)(a) of CDR (EU) 2016/2251.
• the received cash collateral is effectively segregated for the benefit of the covered bond investors, in line with the national requirements transposing Article 12 paragraph 1 CBD.  

The first condition ensures that the purpose of the collateralisation of mitigating the issuer’s/covered bond estate’s exposure to the counterparty in case of (involuntary) early termination of the derivative transaction while the market valuation of the underlying derivative constitutes a claim of the issuer/covered bond estate is met. The second condition is meant to enable the covered bond estate – in case of estate separation – to fulfil the (potentially very short-term) obligation to return the received collateral to the counterparty under an ongoing derivative transaction.

In the absence of the above conditions, cash collateral shall not be considered for netting purposes with respect to derivatives contracts.