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ISDA International Swaps & Derivatives Association

We will give further comments on some of the terms defined in Article 1 when we comment on the operative provisions of the draft RTS.
We note that the definition of “Unpaid Amounts” does not include amounts in respect of interest or compensation accrued during the period from the date on which relevant payment or delivery obligations fell due through to the relevant close-out date. We think this should be corrected.
As the RTS is currently drafted, the definition of “Commercially reasonable replacement trade” is particularly important for counterparties of an institution under resolution. As we will explain later in this response (see our response to Question 4), we believe the assumption within the draft RTS that a counterparty would replace closed-out transactions is incorrect and is not aligned with the standard contractual valuation mechanisms set out in the ISDA Master Agreements which permit quotations to be taken into account for valuation purposes.
However, to the extent that the draft RTS does anticipate that a counterparty would enter into actual replacement transactions and that the price at which it enters into such replacement transactions should be used to determine value for purposes of Article 49, we think that elements of the current definition of “commercially reasonable replacement trade” require amendment. Specifically:
a) we think that requiring the counterparty to have made best efforts to obtain best value for money in order for the replacement trade to be considered commercially reasonable sets an unreasonably high standard. In the context of standard market agreements such as the ISDA Master Agreements, parties are used to having their determinations and discretionary actions tested by reference to standards of commercial reasonableness as interpreted by English courts, for example, applying English law. While there have been, and will continue to be, different interpretations of what is commercially reasonable in any particular context, we submit that the interpretation which is closest to the position reflected in the draft RTS (based on some objective determination of what is commercially reasonable) still imposes a much lower standard than would be understood by a “best efforts/best value” standard. We appreciate the difficulty faced by the EBA in describing a standard which can be applied under other systems of law. We would be happy to discuss this issue in more detail.
b) if, as we would hope is the case, the intention is to allow counterparties to submit details of individual replacement trades each executed to replace a group of closed-out transactions, then this should be clarified. At present, the drafting seems to suggest one-for-one matching of replacement trade with closed-out transaction. This would drive inefficient and non-standard behaviour. We note that the definition requires replacement trades to be entered into on a netted risk exposure basis and agree that it is appropriate (and in the interests of the entity in resolution) for replacement trades to be considered commercially reasonable where they replace a netted risk position rather than a one-for-one replacement of a terminated transaction.
c) we suggest that it would be more appropriate to align the definition with Article 4(1)(b) of the draft RTS to permit counterparties to replace trades or to obtain the economic equivalent of the


material terms of the contracts and the option rights of the parties in respect of the terminated contracts.
d) we suggest that, in order to reduce the likelihood of litigation and subsequent adjustments being made pursuant to the “no creditor worse off” principle, a time period be introduced whereby the counterparty may challenge the determination of the early termination amount calculated by the valuer.
The definition of “write-down and conversion powers” does not need to refer to Article 59(2) of the BRRD as this article is not relevant to derivatives contracts and its reference may cause confusion.
It is important to bear in mind the context of a possible bail-in of derivative liabilities.
Most significant derivative trading relationships involving relevant financial institutions are already fully collateralised and, following the entry into force of EMIR margin requirements, will be required to be fully collateralised on an ongoing basis. It is therefore unlikely that, for these relationships, there will be any unsecured/uncollateralised liabilities which are susceptible to bail-in. The most likely trading relationships to create unsecured/uncollateralised exposures which are susceptible to bail-in (now and in the future) will be trading relationships between financial institutions and their non-financial institution clients; those entities least likely to be able quickly to respond to any forced close-out of derivative transactions in the context of a bail-in.
Most high volume, standardised OTC derivative transactions will be required to be cleared. Article 2 of the draft RTS would not apply to those cleared transactions. Uncleared transactions involving a financial instititution under resolution would therefore likely be illiquid, structured transactions (so not quickly or easily valued) and/or transactions with non-financial counterparties (who are least likely to be able quickly to respond to a forced close-out).
The combination of these factors suggests that the relevant resolution authority should have the flexibility to provide a deadline of more than a few business days depending on the types of counterparty which have contracted with the entity in resolution and in respect of which a bail-in is contemplated.
In addition, we suggest that the draft RTS clarify that the close-out date and the date by which counterparties shall provide evidence of commercially reasonable replacement trades as specified by the resolution authority should, in each case, be a business day.
As you are aware, there are a variety of standard from agreements used in the global OTC derivatives markets. Whilst the valuation principle reflected in Article 4 attempts to synthesise the contractual basis

for determinations of close-out payments in those agreements, as discussed in our responses to Questions 1 and 4, the application of this principle within the draft RTS is not aligned with the standard contractual valuation mechanisms set out in the ISDA Master Agreements in a number of respects (for example, the draft RTS do not expressly permit quotations obtained by the closed-out counterparty to be taken into account for valuation purposes).
We note the reference in Article 4(1)(a) to “collateral” due from the institution under resolution or from the counterparty. We assume this is intended to refer to amounts (such as the amount calculated under Paragraph 6 of the ISDA Credit Support Annex (Bilateral Form – Transfer) (the English law ISDA title transfer CSA)) which reflect the value of collateral previously transferred and which are to be accounted for in the close-out calculation. If this is the intention, we think it would be helpful to clarify that intention. We would be happy to discuss how this could be achieved.
The word “on” in the third line of Article 4(1)(b) should be replaced by “of”.
We agree that preferential status should be given to commercially reasonable replacement trades for purposes of determining value under Article 49 BRRD. However, as per Question 1 above, we believe the assumption within the draft RTS that a counterparty would replace closed-out transactions is incorrect and is not aligned with the standard contractual valuation mechanisms set out in the ISDA Master Agreements which permit quotations to be taken into account for valuation purposes. Whilst it is appreciated that it is not desirable for resolution authorities to be required to consider the particular valuation methodology in every derivatives contract on a case-by-case basis, it is important, as stated in the Consultation, to avoid “discrepancies with the insolvency counterfactual that could lead to breach the non-creditor-worse-off principle”. As such, we believe it is imperative that the valuation mechanism is aligned as closely as possible with the standard contractual valuation mechanisms set out in the ISDA Master Agreements (see the definition of “Market Quotation” in the 1992 ISDA Master Agreement and the definition of “Close-out Amount” in the 2002 ISDA Master Agreement). A key concern relates to the assumption within the draft RTS that a counterparty would replace closed-out transactions. As specified further below, this does not accord with market practice or align with the valuation provisions set out in the ISDA Master Agreements. In addition, fallbacks to mid-market prices are problematic and not market standard.
As to prioritisation among other sources of data, we have the following comments:
1) Article 49(3) BRRD requires the resolution authority or independent valuer to determine the liability arising from derivative transactions subject to a netting agreement in accordance with the terms of the agreement.
2) In drafting the RTS, Article 49(5) BRRD requires the EBA to take into account the methodology for close-out set out in the netting agreement.
3) An ISDA Master Agreement is a netting agreement for this purpose
4) The terms of the ISDA Master Agreement and the methodology for close-out set out in the ISDA Master Agreement provide that the non-defaulting party has, except in the case of Market Quotation under the 1992 ISDA Master Agreement, discretion as to the data sources it can use when determining the value of transactions in a close-out.

5) In particular, a non-defaulting party does not need to replace terminated transactions (either on a portfolio or trade-by-trade basis) in order to validly determine the relevant close-out amount.
6) If the non-defaulting party does in fact replace terminated transactions, then the cost or gain arising from the replacement will be a valid component of the close-out calculation, but, even in relation to the value attributable to the terminated transactions, there might be other factors which could legitimately be taken into account. Additional factors include differences between collateral terms applicable to the terminated and new transactions, differences in terms of trading documentation more generally, as well as funding costs for the counterparty. Consequently, we recommend that Article 4 be amended to allow counterparties to submit “adjusted” replacement values and for those adjusted values to be accepted/rejected by the resolution authority on the basis of commercial reasonableness.
7) If the non-defaulting party does not actually replace the terminated transactions (even in the circumstances where a quote is obtained to replace such transactions), there is no prohibition within the ISDA Master Agreement on the use of other data sources to arrive at a value.
8) To reflect the principles set out in Article 49(3) and Article 49(5) BRRD as summarised above, and in recognition of the terms and methodology of standard market agreements such as the ISDA Master Agreements, we suggest that resolution authorities and independent valuers should be required to take account of valuations provided by counterparties even when determined on the basis of data other than the price of actual replacement trades.
9) We note that the 2002 ISDA Master Agreement sets out (within the definition of the term “Close-out Amount”) a hierarchy of types of information which a determining party may consider when determining close-out values.
10) We also recognise that the difficult task of the resolution authorities in arriving at valuations under Article 49 BRRD will be made easier if they are provided with actual valuations by the counterparties.
11) We therefore suggest that the valuer should be required to determine the early termination amount at the prices of actual commercially reasonable replacement trades or, if no evidence of such actual commercially reasonable replacement trades has been provided by the applicable deadline, by using the value determined by the counterparty, in good faith using commercially reasonable procedures in order to produce a commercially reasonable result, as the relevant close-out amount (ie referring to Article 4(1)(b) of the draft RTS).
12) Article 5(4) of the draft RTS is clarified so as to expressly provide for the valuer to use data sources in the following order of priority:
(i) data provided by third parties, such as market data and quotes from market makers, or values obtained from central counterparties where a contract is centrally cleared (currently Article 5(4)(d) of the draft RTS) – we believe that this data will provide for a more objective valuation than the subsequent data sources and should therefore rank above them;
(ii) data provided by counterparties other than evidence of trades communicated pursuant to Article 2(2) of the draft RTS, including data on current or previous valuation disputes on similar or related transactions (currently Article 5(4)(c) of the draft RTS) – we also recommend that this limb is clarified so as to expressly recognise that a counterparty can provide actual valuations based on data other than executed replacement trades;

(iii) for standardised products, valuations generated by the own systems of the valuer (currently Article 5(4)(a) of the draft RTS);
(iv) data available within the institution under resolution, such as internal models and valuations including independent price verifications performed pursuant to Article 105(8) of Regulation (EU) No 575/2013 (currently Article 5(4)(b) of the draft RTS); and
(v) any other relevant data (currently Article 5(4)(e) of the draft RTS).
13) In respect of Article 5(3) of the draft RTS, we agree that intra-group liabilities should be valued at mid-market prices.
We expect that volatile markets – to be expected if a significant participant in the OTC derivatives market is resolved – would hamper a valuer’s ability to obtain or determine reliable mid-market prices. It is, therefore, all the more important that counterparties are permitted to value derivatives transactions based on other data sources as discussed above (in our response to Question 4).
In respect of Article 5(2)(b), we suggest the words “or re-establishing any hedge or related trading position” are amended to correspond with Article 4(1)(b) to provide for “economic equivalent of material terms of the contract and its option rights of the terminated contracts.”
We suggest that, in line with market practice, the resolution authority should be required to consider additional factors when adjusting the bid-offer spread. Such factors should include position size, market depth, liquidity, contractual terms, hedging costs and cost of funding.
There should be an express recognition that value will be impacted by (i) the cost of funding and (ii) existing collateral arrangements between counterparty and institution under resolution and/or an express assumption as to the terms of any related collateral arrangements.
We feel strongly that the resolution authority or valuer should defer to CCP default procedures to calculate the relevant valuations without fallback to other valuation mechanisms. Equally, valuations of cleared derivatives should be carried out in accordance with the timeframes set out in the CCP default procedures (and not any deadlines imposed by the relevant resolution authority). In addition, the resolution authority or valuer should not conduct any preliminary valuation which is binding on the counterparties in any way as

part of the resolution process (although we have no issue in principle with the resolution or valuer conducting a preliminary valuation for its own purposes as a baseline for comparison). We are happy to discuss this in further detail with the EBA upon request.
We note there are possible adverse consequences for clients of clearing members if their clearing member goes into resolution. This is because transactions between client and clearing member appear not to be excluded from the general valuation provisions set out in Articles 2, 3, 4 and 5. It seems therefore that a client’s positions are at risk of forced close-out and, notwithstanding the terms of the client clearing agreement, a close-out value being determined other than by reference to the CCP’s own determinations. We would be happy to discuss this with the EBA in further detail.
We do see a risk of increased market volatility on the first trading day following the close-out notification. In Article 7(1)(c) of the draft RTS, the test of commercial reasonableness seems to be linked to the question of whether a price is available in the relevant underlying market. We suggest that the test should not be whether a price is available, but whether it is reasonable for a closed-out counterparty to be replacing trades in the market on that day, i.e., would it be reasonable for the resolution authority to impose on the counterparty values derived from prices available on a day when a reasonable counterparty would have been deterred from trading due to the volatile conditions?
If a resolution authority decides to bail in specific counterparties’ net positions based on its estimated values and then corrects the valuations based on input from the counterparty and/or market data, we do consider that this approach significantly increases the risk of litigation. However, it is difficult to see how else a bail-in could be achieved within a reasonable time frame. A solution could be to allow counterparties to query valuations within a specific time frame.
We consider that this alternative approach seems unrealistic.
Please see our response to Question 7.
Please see our response to Question 7.
Yes.
Yes.
The EBA should clarify the reference to collateral exchange to make it clear whether it relates to errors or disputes in the valuation of collateral which is required to be accounted for as part of the close-out calculation. Again, we would be happy to discuss this point in more detail.
The EBA should clarify the reference to collateral exchange to make it clear whether it relates to errors or disputes in the valuation of collateral which is required to be accounted for as part of the close-out calculation. Again, we would be happy to discuss this point in more detail.
ISDA International Swaps & Derivatives Association