Capital requirements for settlement and counterparty risk

Part

BIPRU Prudential sourcebook for Banks, Building Societies and Investment Firms

Chapter

Capital requirements for settlement and counterparty risk

Printed on: 01/11/2024

Rulebook at: 01/01/2010

BIPRU 14

Capital requirements for settlement and counterparty risk

BIPRU 14.1

Application and purpose

01/01/2007

Application

BIPRU 14.1.1

BIPRU 14 applies to a BIPRU firm.

01/01/2007

BIPRU 14.1.2

(1) BIPRU 14.2 deals with the calculation of the capital requirement for CCR for trading book positions arising from financial derivative instruments, securities financing transactions and long settlement transactions. The approaches used to calculate exposure values and risk weighted exposure amounts for these positions are largely based on the approaches applicable to non-trading book positions (BIPRU 3, BIPRU 4, BIPRU 5 and BIPRU 13). However, there are some treatments that are specific to the trading book. These are set out in BIPRU 14.2.
(2) The calculation of the capital requirement for CCR for trading book positions is the first element of the counterparty risk capital component in BIPRU 14.2.1 R. The second element of the counterparty risk capital component is for unsettled transactions in both the trading book and the non-trading book. It is calculated under BIPRU 14.3.
(3) BIPRU 14.4 sets out the treatment for free deliveries.

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Purpose

BIPRU 14.1.3

BIPRU 14 implements:

(1) Article 3(1)(h), Article 17(1), and Article 40; and
(2) Annex II;

of the Capital Adequacy Directive.

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BIPRU 14.2

Calculation of the capital requirement for CCR

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Calculation of the counterparty risk capital component

BIPRU 14.2.1

A firm must calculate the counterparty risk capital component as the sum of:

(1) the capital requirement calculated under BIPRU 14.2.13 R; and
(2) the amount calculated under BIPRU 14.3.

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BIPRU 14.2.2

A firm must hold capital calculated in accordance with BIPRU 14.2.13 R against the CCR arising from exposures arising in the trading book due to the following:

(1) free deliveries (where BIPRU 14.4 requires it to be treated as an exposure);
(2) financial derivative instruments and credit derivatives;
(3) repurchase agreements, reverse repurchase agreements, securities or commodities lending or borrowing transaction based on securities or commodities included in the trading book;
(4) margin lending transactions based on securities or commodities; and
(5) long settlement transactions.

[Note: CAD Annex II point 5]

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Credit derivatives

BIPRU 14.2.3

For the purposes of the calculation of the counterparty risk capital component, a financial derivative instrument means:

(1) an item falling within BIPRU 13.3.3 R other than an item to which an exposure value of zero is attributed under BIPRU 13.3.13 R or BIPRU 13.8.8 R (Exposure to a central counterparty); and
(2) a credit derivative.

[Note: CAD Article 3(1)(h) and Annex II point 7 first sentence]

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BIPRU 14.2.4

BIPRU 14.2.5 R to BIPRU 14.2.8 R apply for the purposes of BIPRU 13.4 (CCR mark to market method).

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BIPRU 14.2.5

In the case of total return swap credit derivatives and credit default swap credit derivatives, a firm must obtain a figure for potential future credit exposure by multiplying the nominal amount of the instrument by the following percentages:

(1) 5% where the reference obligation is one that if it gave rise to a direct exposure of the firm would be a qualifying debt security for the purposes of BIPRU 7.2;
(2) 10 % where the reference obligation is one that if it gave rise to a direct exposure of the firm would not be a qualifying debt security for the purposes of BIPRU 7.2.

[Note: CAD Annex II point 7 (part)]

01/01/2007

BIPRU 14.2.6

In the case of a credit default swap, a firm the exposure of which arising from the swap represents a long position in the underlying may use a figure of 0% for potential future credit exposure, unless the credit default swap is subject to closeout upon the insolvency of the entity the exposure of which arising from the swap represents a short position in the underlying, even though the underlying has not defaulted.

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BIPRU 14.2.7

BIPRU 14.2.6 R permits the seller of credit protection to determine potential future credit exposure as 0%, unless the protection is subject to close-out on the insolvency of the buyer.

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BIPRU 14.2.8

Where the credit derivative provides protection in relation to 'nth to default' amongst a number of underlying obligations, a firm must apply the percentage figure in BIPRU 14.2.5 R applicable to the obligation with the nth lowest credit quality determined by whether it is one that if incurred by the firm would be a qualifying debt security for the purposes of BIPRU 7.2.

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BIPRU 14.2.9

The operation of BIPRU 14.2.8 R can be illustrated by an example as follows: where the credit derivative is a first to default transaction, the appropriate percentage for the potential future credit exposure will be determined by the lowest credit quality of the underlying obligations in the basket. If there are non-qualifying items in the basket, the percentage applicable to the non-qualifying reference obligation should be used. For second and subsequent to default transactions, underlying assets should continue to be allocated according to credit quality: i.e. for a second to default transaction, the applicable percentage figure is the percentage applicable to the second lowest credit quality.

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BIPRU 14.2.10

Where a credit derivative included in the trading book forms part of an internal hedge and the credit protection is recognised for the purposes of the calculation of the credit risk capital component, there is deemed to be no counterparty risk arising from the position in the credit derivative.

[Note: CAD Annex II point 11]

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Calculation

BIPRU 14.2.11

Subject to BIPRU 14.2.3 R to BIPRU 14.2.5 R and BIPRU 14.2.14 R to BIPRU 14.2.17 R, a firm must calculate exposure values and risk weighted exposure amounts for the exposures falling under BIPRU 14.2.2 R (1) to BIPRU 14.2.2R (5) in accordance with:

(1) the standardised approach to credit risk; or
(2) if the firm has an IRB permission, the IRB approach in accordance with the terms of the firm's IRB permission.

[Note: CAD Annex II point 6]

01/01/2007

BIPRU 14.2.12

For the purpose of calculating counterparty exposure values for financial derivative instruments, securities financing transactions and long settlement transactions, or for credit risk mitigation, the effect of BIPRU 14.2.11 R is to direct a firm to BIPRU 13 or BIPRU 5 as appropriate.

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BIPRU 14.2.13

A firm must calculate the capital requirement for the purposes of BIPRU 14.2.2 R as 8% of the total risk weighted exposure amounts.

[Note: CAD Annex II point 12]

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Collateral

BIPRU 14.2.14

For the purposes of BIPRU 14.2.11 R, in calculating risk weighted exposure amounts a firm must not use the financial collateral simple method for the recognition of the effects of financial collateral.

[Note: CAD Annex II point 8]

01/01/2007

BIPRU 14.2.15

For the purposes of BIPRU 14.2.11 R:

(1) in the case of repurchase transactions and securities or commodities lending or borrowing transactions booked in the trading book, all CRD financial instruments and commodities that are eligible to be included in the trading book may be recognised as eligible collateral;
(2) for exposures due to financial derivative instruments and long settlement transactions booked in the trading book, commodities that are eligible to be included in the trading book may also be recognised as eligible collateral;
(3) for the purposes of calculating volatility adjustments where such CAD financial instruments or commodities which are not eligible under BIPRU 5 and BIPRU 4.10 are lent, sold or provided, or borrowed, purchased or received by way of collateral or otherwise under such a transaction, and the firm is using the supervisory volatility adjustments approach, such instruments and commodities must be treated in the same way as non-main index equities listed on a recognised investment exchange or a designated investment exchange.

[Note: CAD Annex II point 9 (part)]

01/01/2007

BIPRU 14.2.16

(1) Where a firm is using the own estimates of volatility adjustments approach in respect of CAD financial instruments or commodities which are not eligible under BIPRU 5 and BIPRU 4.10 it must calculate volatility adjustments for each individual item.
(2) Where a firm is using the master netting agreement internal models approach set out in BIPRU 5, it may also apply this approach in the trading book.

[Note: CAD Annex II point 9 (part)]

01/01/2007

BIPRU 14.2.17

For the purposes of BIPRU 14.2.11 R, in relation to the recognition of master netting agreements covering repurchase transactions and/or securities or commodities lending or borrowing transactions and/or other capital market-driven transactions netting across positions in the trading book and the non-trading book may only be recognised when the netted transactions fulfil the following conditions:

(1) all transactions are marked to market daily;
(2) any items borrowed, purchased or received under the transactions may be recognised as eligible financial collateral under BIPRU 5 and BIPRU 4.10 without the application of BIPRU 14.2.14 R to BIPRU 14.2.15 R.

[Note: CAD Annex II point 9 (part)]

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Treatment of expected loss amounts under the IRB approach

BIPRU 14.2.18

Where a firm calculates risk weighted exposure amounts for the purposes of BIPRU 14 in accordance with the IRB approach, then for the purposes of the calculation provided for in BIPRU 4.4.79 R (Double default), the following apply:

(1) value adjustments made to take account of the credit quality of the counterparty may be included in the sum of value adjustments and provisions made for the exposures indicated in BIPRU 14; and
(2) unless the firm's IRB permission does not permit it, if the credit risk of the counterparty is adequately taken into account in the valuation of a position included in the trading book the expected loss amount for the counterparty risk exposure must be zero.

[Note: CAD Article 17(1)]

01/01/2007

Exposures to recognised third-country investment firms, recognised clearing houses and designated investment exchanges

BIPRU 14.2.20

For the purposes of the calculation of the counterparty risk capital component, without prejudice to BIPRU 13.3.13 R and BIPRU 13.8.8 R (Exposure to a central counterparty) exposures to recognised third-country investment firms and exposures incurred to recognised clearing houses and designated investment exchanges must be treated as exposures to institutions.

[Note: CAD Article 40]

01/01/2007

Netting of trading book exposures against non-trading book exposures

BIPRU 14.2.21

For the purposes of counterparty credit risk, a firm may net exposures arising from items in the trading book against exposures arising from items in the non-trading book.

01/01/2007

BIPRU 14.2.22

Where a firm carries out netting under BIPRU 14.2.21 R, it must allocate the net exposure to:

(1) the trading book for the purposes of the calculation under BIPRU 14.2.11 R, if the gross trading book exposures exceed gross non-trading book exposures; and
(2) the non-trading book for the purposes of BIPRU 13, if the gross non-trading book exposures exceed gross trading book exposures.

01/01/2007

BIPRU 14.2.23

A firm may only net exposures under BIPRU 14.2.21 R if it continues to meet other GENPRU and BIPRU requirements applicable to the trading book or non-trading book in respect of those exposures.

01/01/2007

BIPRU 14.2.24

For example, in relation to BIPRU 14.2.23 R, collateral which is eligible only against trading book exposures will not be applicable against non-trading book exposures; and the large exposures limits on non-trading book positions will also remain applicable.

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BIPRU 14.3

Unsettled transactions

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Scope

BIPRU 14.3.1

BIPRU 14.3 applies in respect of items in the trading book and the non-trading book.

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BIPRU 14.3.2

The capital requirement for unsettled transactions is an element of the counterparty risk capital component set out in BIPRU 14.2.1 R.

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Calculation

BIPRU 14.3.3

In the case of transactions in which debt instruments, equities, foreign currencies and commodities (excluding repurchase agreements and reverse repurchase agreements and securities or commodities lending and securities or commodities borrowing) are unsettled after their due delivery dates, a firm must calculate the price difference to which it is exposed, being the difference between the agreed settlement price for the debt instrument, equity, foreign currency or commodity in question and its current market value, where the difference could involve a loss for the firm.

[Note: CAD Annex II point 1 (part)]

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BIPRU 14.3.4

A firm must multiply the price difference calculated under BIPRU 14.3.3 R by the appropriate factor in column A of the Table in BIPRU 14.3.4 R in order to calculate its capital requirement for the purposes of BIPRU 14.3.

[Note: CAD Annex II point 1 (part)]

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Table: Factors for the multiplication of price differences

BIPRU 14.3.5

This table belongs to BIPRU 14.3.4 R

Number of working days after due settlement date

Column A (%)

5 - 15

16 - 30

31 - 45

46 or more

100

[Note: CAD Annex II Table 1]

01/01/2007

BIPRU 14.3.5

In cases of a system wide failure of a settlement or clearing system, a firm should refer to the emergency provisions in GEN 1.3. Where the requirements of GEN 1.3.2 R are met, until the situation is rectified failure of a counterparty to settle a trade will not be deemed a default for purposes of credit risk.

[Note: CAD Annex II point 4]

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BIPRU 14.4

Free deliveries

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Scope

BIPRU 14.4.1

BIPRU 14.4 applies in respect of items in the trading book and the non-trading book.

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BIPRU 14.4.2

A firm must hold capital resources with respect to a free delivery, as set out in the Table in BIPRU 14.4.3 R, if:

(1) it has paid for securities, foreign currencies or commodities before receiving them or it has delivered securities foreign currencies or commodities before receiving payment for them; and
(2) in the case of cross-border transactions, one day or more has elapsed since it made that payment or delivery.

[Note: CAD Annex II point 2]

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Exposure

BIPRU 14.4.3

Table: Capital treatment for free deliveries
This table belongs to BIPRU 14.4.2 R.

Transaction Type

Up to first contractual payment leg or delivery leg

From first contractual payment leg or delivery leg up to four days after second contractual payment leg or delivery leg

From 5 business days post second contractual payment leg or delivery leg until extinction of the transaction

Free delivery

No capital charge in the trading book

Treat as an exposure

Deduct value transferred plus current positive exposure from capital resources

[Note: CAD Annex II Table 2]

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BIPRU 14.4.4

(1) In the case of the non-trading book, a firm must treat an exposure falling into columns 2 and 3 of the table in BIPRU 14.4.3 R in accordance with the relevant provisions of the standardised approach to credit risk or the IRB approach, as the case may be.
(2) In the case of the trading book, a firm must apply the treatment set out in BIPRU 14.4.5 R.

[Note: CAD Annex II point 3 (part)]

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BIPRU 14.4.5

(1) In applying a risk weight to free delivery exposures treated according to column 3 of the table in BIPRU 14.4.3 R, a firm using the IRB approach may assign PD to counterparties, for which they have no other non-trading book exposure, on the basis of the counterparty's external rating.
(2) A firm using own estimates of LGDs may apply the LGD set out in BIPRU 4.4.34 R to BIPRU 4.4.35 R BIPRU 4.4.35 R (IRB foundation approach: LGDs) to free delivery exposures treated according to column 3 of the table in BIPRU 14.4.3 R, provided that it applies it to all such exposures.
(3) Alternatively, a firm using the IRB approach may apply the risk weights, as set out in the standardised approach to credit risk provided that it applies them to all such exposures or may apply a 100% risk weight to all such exposures.

[Note: CAD Annex II point 3 (part)]

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BIPRU 14.4.6

If the amount of positive exposure resulting from free delivery transactions is not material, a firm may apply a risk weight of 100% to these exposures.

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BIPRU 14.4.7

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