BIPRU 5.6 Master netting agreements

1. (1)

   For a firm adopting the financial collateral comprehensive method, the effects of bilateral netting contracts covering repurchase transactions, securities or commodities lending or borrowing transactions, and/or other capital market-driven transactions with a counterparty may be recognised.

2. (2)

   Without prejudice to BIPRU 14 to be recognised the collateral taken and securities or commodities borrowed within such agreements must comply with the eligibility requirements for collateral set out at BIPRU 5.4.2 R to BIPRU 5.4.8 R.

   [Note: BCD Annex VIII Part 1 point 5]

For master netting agreements covering repurchase transactions and/or securities or commodities lending or borrowing transactions and/or other capital market-driven transactions1 to be recognised for the purposes of BIPRU 5, they must:

1. (1)

   be legally effective and enforceable in all relevant jurisdictions, including in the event of the bankruptcy or insolvency of the counterparty;

2. (2)

   give the non-defaulting party the right to terminate and close-out in a timely manner all transactions under the agreement upon the event of default, including in the event of the bankruptcy or insolvency of the counterparty; and

3. (3)

   provide for the netting of gains and losses on transactions closed out under a master agreement so that a single net amount is owed by one party to the other.

   [Note: BCD Annex VIII Part 2 point 4]

In addition the minimum requirements for the recognition of financial collateral under the financial collateral comprehensive method set out in BIPRU 5.4.9 R must be fulfilled.

[Note: BCD Annex VIII Part 2 point 5]

BIPRU 5.6.5 R to BIPRU 5.6.11 R set out the calculation of the fully adjusted exposure value under the supervisory volatility adjustments approach and the own estimates of volatility adjustments approach.

In calculating the ‘fully adjusted exposure value’ (E^*) for the exposures subject to an eligible master netting agreement covering repurchase transactions and/or securities or commodities lending or borrowing transactions and/or other capital market-driven transactions, a firm must calculate the volatility adjustments to be applied in the manner set out in BIPRU 5.6.6 R to BIPRU 5.6.11 R either using the supervisory volatility adjustments approach or the own estimates of volatility adjustments approach as set out in BIPRU 5.4.30 R to BIPRU 5.4.65 R for the financial collateral comprehensive method. For the use of the own estimates of volatility adjustments approach the same conditions and requirements apply as under the financial collateral comprehensive method.

[Note: BCD Annex VIII Part 3 point 5]

A firm must calculate the net position in each type of security or commodity by subtracting from the total value of the securities or commodities of that type lent, sold or provided under the master netting agreement, the total value of securities or commodities of that type borrowed, purchased or received under the agreement.

[Note: BCD Annex VIII Part 3 point 6]

For the purposes of BIPRU 5.6.6 R, type of security means securities which are issued by the same entity, have the same issue date, the same maturity and are subject to the same terms and conditions and are subject to the same liquidation periods as indicated in BIPRU 5.4.30 R to BIPRU 5.4.65 R.

[Note: BCD Annex VIII Part 3 point 7]

A firm must calculate the net position in each currency other than the settlement currency of the master netting agreement by subtracting from the total value of securities denominated in that currency lent, sold or provided under the master netting agreement added to the amount of cash in that currency lent or transferred under the agreement, the total value of securities denominated in that currency borrowed, purchased or received under the agreement added to the amount of cash in that currency borrowed or received under the agreement.

[Note: BCD Annex VIII Part 3 point 8]

A firm must apply the volatility adjustment appropriate to a given type of security or cash position to the absolute value of the positive or negative net position in the securities of that type.

[Note: BCD Annex VIII Part 3 point 9]

A firm must apply the foreign exchange risk (fx) volatility adjustment to the net positive or negative position in each currency other than the settlement currency of the master netting agreement.

[Note: BCD Annex VIII Part 3 point 10]

E^* must be calculated according to the following formula:

E^* = max {0, [(∑(E) -∑ (C)) + ∑ (|net position in each security| x H_sec) + (∑|E_fx| x H_fx)]}

where:

1. (1)

   (where risk weighted exposure amounts are calculated under the standardised approach) E is the exposure value for each separate exposure under the agreement that would apply in the absence of the credit protection;

2. (2)

   C is the value of the securities or commodities borrowed, purchased or received or the cash borrowed or received in respect of each such exposure;

3. (3)

   ∑(E) is the sum of all Es under the agreement;

4. (4)

   ∑(C) is the sum of all Cs under the agreement;

5. (5)

   E_fx is the net position (positive or negative) in a given currency other than the settlement currency of the agreement as calculated under BIPRU 5.6.8 R;

6. (6)

   H_sec is the volatility adjustment appropriate to a particular type of security;

7. (7)

   H_fx is the foreign exchange volatility adjustment; and

8. (8)

   E^* is the fully adjusted exposure value.

   [Note: BCD Annex VIII Part 3 point 11]

BIPRU 5.6.16 R to BIPRU 5.6.28 G apply to a firm that has a master netting agreement internal models approach permission and set out the calculation of the effects of credit risk mitigation under the master netting agreement internal models approach.

The master netting agreement internal models approach1 is an alternative to using the supervisory volatility adjustments approach or the own estimates of volatility adjustments approach in calculating volatility adjustments for the purpose of calculating the ‘fully adjusted exposure value’ (E^*) resulting from the application of an eligible master netting agreement covering repurchase transactions, securities or commodities lending or borrowing transactions and/or other capital market-driven transactions other than derivative transactions. The master netting agreement internal models approach takes into account correlation effects between security positions subject to a master netting agreement as well as the liquidity of the instruments concerned. The internal model used for the master netting agreement internal models approach must provide estimates of the potential change in value of the unsecured exposure amount (∑E -∑C).

[Note: BCD Annex VIII Part 3 point 12 (part)]

A firm may also use the internal model used for the master netting agreement internal models approach1 for margin lending transactions if the transactions are covered under the firm's master netting agreement internal models approach permission and the transactions are covered by a bilateral master netting agreement that meets the requirements set out in BIPRU 13.7.

[Note: BCD Annex VIII Part 3 point 12 (part)]

A firm may use the master netting agreement internal models approach independently of the choice it has made between the standardised approach and the IRB approach for the calculation of risk weighted exposure amounts. However, if a firm uses the master netting agreement internal models approach, it must do so for all counterparties and securities, excluding immaterial portfolios where it may use the supervisory volatility adjustments approach or the own estimates of volatility adjustments approach as set out in BIPRU 5.4.30 R to BIPRU 5.4.65 R.

[Note: BCD Annex VIII Part 3 point 13]

1. (1)

   A firm must be able to satisfy the FSA that the firm's risk management system for managing the risks arising on the transactions covered by the master netting agreement is conceptually sound and implemented with integrity and that, in particular, the minimum qualitative standards in (2) – (11) are met.

2. (2)

   The internal risk-measurement model used for calculation of potential price volatility for the transactions is closely integrated into the daily risk-management process of the firm and serves as the basis for reporting risk exposures to senior management of the firm.

3. (3)

   The firm has a risk control unit that is independent from business trading units and reports directly to senior management. The unit must be responsible for designing and implementing the firm's risk-management system. It must produce and analyse daily reports on the output of the risk-measurement model and on the appropriate measures to be taken in terms of position limits.

4. (4)

   The daily reports produced by the risk-control unit are reviewed by a level of management with sufficient authority to enforce reductions of positions taken and of overall risk exposure.

5. (5)

   The firm has sufficient staff skilled in the use of sophisticated models in the risk control unit.

6. (6)

   The firm has established procedures for monitoring and ensuring compliance with a documented set of internal policies and controls concerning the overall operation of the risk-measurement system.

7. (7)

   The firm's models have a proven track record of reasonable accuracy in measuring risks demonstrated through the back-testing of its output using at least one year of data.

8. (8)

   The firm frequently conducts a rigorous programme of stress testing and the results of these tests are reviewed by senior management and reflected in the policies and limits it sets.

9. (9)

   The firm must conduct, as part of its regular internal auditing process, an independent review of its risk-measurement system. This review must include both the activities of the business trading units and of the independent risk-control unit.

10. (10)

    At least once a year, the firm must conduct a review of its risk management system.

11. (11)

    The internal model used for the master netting agreement internal models approach1 must meet the requirements set out in BIPRU 13.6.65 R to BIPRU 13.6.67 R.

    [Note: BCD Annex VIII Part 3 point 16]

The calculation of the potential change in value must be subject to the following minimum standards:

1. (1)

   at least daily calculation of the potential change in value;

2. (2)

   a 99th percentile, one-tailed confidence interval;

3. (3)

   a 5-day equivalent liquidation period, except in the case of transactions other than securities repurchase transaction or securities lending or borrowing transactions where a 10-day equivalent liquidation period should be used;

4. (4)

   an effective historical observation period of at least one year except where a shorter observation period is justified by a significant upsurge in price volatility; and

5. (5)

   three-monthly data set updates.

   [Note: BCD Annex VIII Part 3 point 17]

The internal risk-measurement model must capture a sufficient number of risk factors in order to capture all material price risks.

[Note: BCD Annex VIII Part 3 point 18]

A firm may use empirical correlations within risk categories and across risk categories provided that it is able to satisfy the FSA that the firm's system for measuring correlations is sound and implemented with integrity.

[Note: BCD Annex VIII Part 3 point 19]

The fully adjusted exposure value (E^*) for a firm using the master netting agreement internal models approach must be calculated according to the following formula:

E^* = max {0, [(∑E -∑C) + (VaR output of the internal models)]}

where

1. (1)

   (where risk weighted exposure amounts are calculated under the standardised approach) E is the exposure value for each separate exposure under the agreement that would apply in the absence of the credit protection;

2. (2)

   C is the value of the securities borrowed, purchased or received or the cash borrowed or received in respect of each such exposure;

3. (3)

   ∑ (E) is the sum of all Es under the agreement; and

4. (4)

   ∑ (C) is the sum of all Cs under the agreement.

   [Note: BCD Annex VIII Part 3 point 20]

In calculating risk weighted exposure amounts using the master netting agreement internal models approach, a firm must use the previous business day's model output.

[Note: BCD Annex VIII Part 3 point 21]

1. (1)

   A firm must under the standardised approach calculate risk weighted exposure amounts for repurchase transactions and/or securities or commodities lending or borrowing transactions and/or other capital market-driven transactions covered by master netting agreements under this rule.

2. (2)

   E^* as calculated under BIPRU 5.6.5 R to BIPRU 5.6.25 R must be taken as the exposure value of the exposure to the counterparty arising from the transactions subject to the master netting agreement for the purposes of BIPRU 3.2.20 R to BIPRU 3.2.26 R.

   [Note: BCD Annex VIII Part 3 point 22]