BIPRU 7.11 Credit derivatives in the trading book

This section applies to the treatment of credit derivatives in the trading book.

BIPRU 7.11.3R - BIPRU 7.11.11R relate to the treatment of the protection seller for the purpose of calculating the securities PRR. Positions are determined in accordance with BIPRU 7.11.4R - BIPRU 7.11.11R.

When calculating the PRR of the protection seller, unless specified differently by other rules, the notional amount of the credit derivative contract must be used. For the purpose of calculating the specific risk PRR charge, other than for total return swaps, the maturity of the credit derivative contract is applicable instead of the maturity of the obligation.

A total return swap creates a long position in the general market risk of the reference obligation and a short position in the general market risk of a zero-specific-risk security with a maturity equivalent to the period until the next interest fixing and which is assigned a 0% risk weight under the standardised approach to credit risk. It also creates a long position in the specific risk of the reference obligation.

A credit default swap does not create a position for general market risk. For the purposes of specific risk, a firm must record a synthetic long position in an obligation of the reference entity, unless the derivative is rated externally and meets the conditions for a qualifying debt security, in which case a long position in the derivative is recorded. If premium or interest payments are due under the product, these cash flows must be represented as notional positions in zero-specific-risk securities.

A single name credit linked note creates a long position in the general market risk of the note itself, as an interest rate product. For the purpose of specific risk, a synthetic long position is created in an obligation of the reference entity. An additional long position is created in the issuer of the note. Where the credit linked note has an external rating and meets the conditions for a qualifying debt security, a single long position with the specific risk of the note need only be recorded.

In addition to a long position in the specific risk of the issuer of the note, a multiple name credit linked note providing proportional protection creates a position in each reference entity, with the total notional amount of the contract assigned across the positions according to the proportion of the total notional amount that each exposure to a reference entity represents. Where more than one obligation of a reference entity can be selected, the obligation with the highest risk weighting determines the specific risk.

Where a multiple name credit linked note has an external rating and meets the conditions for a qualifying debt security, a single long position with the specific risk of the note need only be recorded.

A first-asset-to-default credit derivative creates a position for the notional amount in an obligation of each reference entity. If the size of the maximum credit event payment is lower than the PRR requirement under the method in the first sentence of this rule, the maximum payment amount may be taken as the PRR requirement for specific risk.

A second-asset-to-default credit derivative creates a position for the notional amount in an obligation of each reference entity less one (that with the lowest specific risk PRR requirement). If the size of the maximum credit event payment is lower than the PRR requirement under the method in the first sentence of this rule, this amount may be taken as the PRR requirement for specific risk.

If a first or second-asset to default derivative is externally rated and meets the conditions for a qualifying debt security, then the protection seller need only calculate one specific risk charge reflecting the rating of the derivative.

For the protection buyer, the positions are determined as the mirror principle 3of the protection seller, with the exception of a credit linked note (which entails no short position in the issuer). If at a given moment there is a call option in combination with a step-up, such moment is treated as the maturity of the protection. In the case of first-to-default credit derivatives and3 n^th to default credit derivatives, the treatment in BIPRU 7.11.12AR and BIPRU 7.11.12B R applies instead of the mirror principle3.

[Note: CAD Annex I point 8.B]

3Where a firm obtains credit protection for a number of reference entities underlying a credit derivative under the terms that the first default among the assets will trigger payment and that this credit event will terminate the contract, the firm may off-set specific risk for the reference entity to which the lowest specific risk percentage charge among the underlying reference entities applies according to the Table in BIPRU 7.2.44R.

[Note: CAD Annex I point 8.B]

3Where the n^th default among the exposures triggers payment under the credit protection, the protection buyer may only off-set specific risk if protection has also been obtained for defaults 1 to n-1 or when n-1 defaults have already occurred. In those cases, the methodology set out in BIPRU 7.11.12AR for first-to-default credit derivatives must be followed, appropriately modified for n^th-to-default products.

[Note: CAD Annex I point 8.B]

1. (1)

   BIPRU 7.11.14R - BIPRU 7.11.17R relate to specific risk PRR for trading book positions hedged by credit derivatives for the purposes of the calculation of the securities PRR.

2. (2)

   A firm may take an allowance for protection provided by credit derivatives for the purposes in (1) in accordance with the principles set out in the rules referred to in (1).

3. (3)

   BIPRU 7.11.13 R - BIPRU 7.11.17 R are subject to the requirements of the credit default swap PRR methods.

1. (1)

   A firm may take full allowance when the value of two legs always move in the opposite direction and broadly to the same extent.

2. (2)

   This will be the case in the following situations:

   1. (a)

      the two legs consist of completely identical instruments; or

   2. (b)

      a long cash position is hedged by a total rate of return swap (or vice versa) and there is an exact match between the reference obligation and the underlying exposure (i.e., the cash position).

3. (3)

   The maturity of the swap itself may be different from that of the underlying exposure for the purposes of (2)(b).

4. (4)

   In these situations, a firm must not apply a specific risk PRR to either side of the position.

An 80% offset may be applied when the value of two legs always move in the opposite direction and where there is an exact match in terms of the reference obligation, the maturity of both the reference obligation and the credit derivative, and the currency of the underlying exposure. In addition, key features of the credit derivative contract must not cause the price movement of the credit derivative materially to deviate from the price movements of the cash position. To the extent that the transaction transfers risk, an 80% specific risk offset may be applied to the side of the transaction with the higher PRR, while the specific risk requirements on the other side are zero.

1. (1)

   A firm may take partial allowance when the value of two legs usually move in the opposite direction. This would be the case in the situations set out in (2) - (4).

2. (2)

   The first situation referred to in (1) is that the position falls under BIPRU 7.11.16 R (2)(b) but there is an asset mismatch between the reference obligation and the underlying exposure. However, the positions meet the following requirements:

   1. (a)

      the reference obligation ranks pari passu with or is junior to the underlying obligation; and

   2. (b)

      the underlying obligation and reference obligation share the same obligor and have legally enforceable cross-default or cross-acceleration clauses.

3. (3)

   The second situation referred to in (1) is that the position falls under BIPRU 7.11.14 R (2)(a) or BIPRU 7.11.15 R but there is a currency or maturity mismatch between the credit protection and the underlying asset (currency mismatches must be included in the normal reporting with respect to the foreign currency PRR1).

4. (4)

   The third situation referred to in (1) is that the position falls under BIPRU 7.11.15 R but there is an asset mismatch between the cash position and the credit derivative. However, the underlying asset is included in the (deliverable) obligations in the credit derivative documentation.

5. (5)

   In each of those situations, rather than adding the specific risk PRR requirements for each side of the transaction, only the higher of the two PRR requirements applies.

In all situations not falling under BIPRU 7.11.14 R - BIPRU 7.11.16 R, a firm must assess a specific risk PRR charge against both sides of the positions.

BIPRU 7.11.18 R - BIPRU 7.11.58 R set out the calculation of the specific risk portion of the interest rate PRR for credit default swaps.

The specific risk portion of the interest rate PRR is calculated separately for:

1. (1)

   credit default swaps (other than those in (2));

2. (2)

   credit default swaps that are also securitisation positions; and

3. (3)

   other positions;

that are subject to the interest rate PRR.

The specific risk portion of the interest rate PRR for positions falling into BIPRU 7.11.19 R (1) and BIPRU 7.11.19 R (2) must be calculated in accordance with the credit default swap PRR methods rather than in accordance with BIPRU 7.2 (Interest rate PRR) and the other provisions of BIPRU 7.11. However a firm may apply BIPRU 7.11.13 R- BIPRU 7.11.17 R before applying the credit default swap PRR methods. If it does so the firm must apply the credit default swap PRR methods to the remaining position in credit default swaps.

In accordance with the principle in BIPRU 7.11.19 R, there is no netting for the purpose of calculating specific risk PRR charges (BIPRU 7.2.37 R - BIPRU 7.2.40 R (Deriving the net position in each debt security: Netting positions in the same debt security) or otherwise) between:

1. (1)

   a position falling into BIPRU 7.11.19 R (1) or BIPRU 7.11.19 R (2) and one falling into BIPRU 7.11.19 R (3); or

2. (2)

   a position falling into BIPRU 7.11.19 R (1) and one falling into BIPRU 7.11.19 R (2).

1. (1)

   A firm must calculate the interest rate PRR for specific risk for credit default swaps falling into BIPRU 7.11.19 R (1) under the ordinary credit default swap PRR method.

2. (2)

   A firm must calculate the interest rate PRR for specific risk for credit default swaps falling into BIPRU 7.11.19 R (2) under the securitisation credit default swap PRR method.

BIPRU 7.11.24 R - BIPRU 7.11.37 R set out the ordinary credit default swap PRR method.

A firm must group together all credit default swaps being treated under the ordinary credit default swap PRR method that give rise to notional positions in the same security for specific risk purposes under the procedure in BIPRU 7.11.2 R - BIPRU 7.11.12 R and that may be netted under BIPRU 7.11.56 R.

The provisions in BIPRU 7.11.2 R - BIPRU 7.11.12 R about the creation of a specific risk charge for credit default swaps reflecting the rating of the derivative (see BIPRU 7.11.11 R and part of BIPRU 7.11.5 R) do not apply for the purposes of calculating the ordinary credit default swap PRR method.

The specific risk portion of the interest rate PRR or credit default swaps treated under the ordinary credit default swap PRR method is the higher of:

1. (1)

   an amount equal to what would have been the specific risk portion of the interest rate PRR for such credit default swaps if it had been calculated under of BIPRU 7.2.43 R to BIPRU 7.2.50 R (Specific risk calculation for interest rate risk), taking into account BIPRU 7.11.19 R and BIPRU 7.11.21 R; and

2. (2)

   the sum of the valuation change capital charge (see BIPRU 7.11.28 R) and the default capital charge (see BIPRU 7.11.36 R) for all such credit derivatives.

A firm must allocate each credit default swap grouped together under BIPRU 7.11.24 R to the time bands set out in BIPRU 7.11.33 R for the purposes of calculating the valuation change capital charge.

The valuation change capital charge for a group of credit default swaps created under BIPRU 7.11.24 R is equal to three2 multiplied by the larger of the potential loss produced under BIPRU 7.11.29 R and the potential loss produced under BIPRU 7.11.30 R. The total valuation change capital charge for credit default swaps treated under the ordinary credit default swap PRR method is equal to the sum of such amounts for all such groups.

1. (1)

   The amount of the potential loss calculated under this rule is calculated as follows.

2. (2)

   Within each time band the firm must calculate the net valuation change in the credit default swaps that would occur if spreads (as defined in BIPRU 7.11.55 R) were to increase by the amount shown in BIPRU 7.11.34 R. The amount of the change in spread is the same for each time band.

3. (3)

   The potential loss calculated under this rule is the sum of all bands that create a net loss. Bands which produce a profit must be ignored.

4. (4)

   The time bands referred to in this rule are those established under BIPRU 7.11.27 R.

The amount of the potential loss calculated under this rule is calculated in the same way as it is under BIPRU 7.11.29 R except that the net valuation change is the one that would occur if spreads were to decrease by the amount shown in BIPRU 7.11.34 R.

The valuation change in BIPRU 7.11.29 R - BIPRU 7.11.30 R is applied to the current value of the credit default swap.

The credit quality step applicable under the table in BIPRU 7.11.34 R is that which would be attributable to the security in question under the standardised approach to credit risk. If a rating from an eligible ECAI is not available to the firm it must treat that position as having credit quality step 6. The security in question is the one by reference to which the grouping under BIPRU 7.11.24 R is carried out (the reference entity).

1. (1)

   This rule applies if BIPRU 7.11.24 R results in a credit default swap being split into positions in more than one security.

2. (2)

   The firm must, for each notional security produced as described in (1), apply to the whole of the credit default swap in question the stresses in the table in BIPRU 7.11.34 R using the credit quality step in the table in BIPRU 7.11.34 R for that security.

3. (3)

   The firm must then allocate the different changes in the value of the credit default swap under (2) between the calculations for each security produced as described in (1) on a proportional basis in accordance with the principles in BIPRU 7.11.2 R - BIPRU 7.11.12 R. The firm must do this by multiplying the amount of the change in (2) calculated with respect to the security in question by a fraction based on the proportion of the credit default swap attributable to the security under those principles.

The default capital charge for each group of credit default swaps created under BIPRU 7.11.24 R is equal to two2 multiplied by the amount in BIPRU 7.11.37 R. The total default capital charge for credit default swaps treated under the ordinary credit default swap PRR method is equal to the sum of such amounts for each such group.

1. (1)

   The amount calculated under this rule is the amount resulting from the calculation in (5).

2. (2)

   A firm must fully net all notional positions along a timeline by calculating, for all credit default swaps in the group in question created under BIPRU 7.11.24 R, the net positions in the security in question for all times in the future until those positions expire or otherwise cease to exist.

3. (3)

   The firm must calculate the net positions under (2) in accordance with BIPRU 7.2.37 R - BIPRU 7.2.40 R (Deriving the net position in each debt security: Netting positions in the same debt security).

4. (4)

   The firm must identify the largest long position to which it is exposed over the next year.

5. (5)

   The firm must then multiply the amount established under (4) by the appropriate PRA that would have applied for the purpose of calculating the specific risk portion of the interest rate PRR under BIPRU 7.2 (Interest rate PRR).

6. (6)

   The security in question is the one by reference to which the grouping under BIPRU 7.11.24 R is carried out (the reference entity).

BIPRU 7.11.39 R - BIPRU 7.11.53 R set out the securitisation credit default swap PRR method.

The specific risk portion of the interest rate PRR for credit default swaps treated under the securitisation credit default swap PRR method is the higher of:

1. (1)

   an amount equal to what would have been the specific risk portion of the interest rate PRR for such credit default swaps if it had been calculated under of BIPRU 7.2.43 R to BIPRU 7.2.50 R (Specific risk calculation for interest rate risk), taking into account BIPRU 7.11.19 R and BIPRU 7.11.21 R; and

2. (2)

   the sum of the valuation change capital charge (see BIPRU 7.11.40 R) and the default capital charge (see BIPRU 7.11.48 R) for all such credit derivatives.

In order to calculate the valuation change capital charge a firm must group together each credit default swap that relates to the same securitisation. The valuation change capital charge for each such group is equal to three2 multiplied by the potential loss amount in BIPRU 7.11.41 R. The total valuation change capital charge for credit default swaps treated under the securitisation credit default swap PRR method is equal to the sum of such amounts for each such group.

1. (1)

   The potential loss amount as referred to in BIPRU 7.11.40 R for a group of credit default swaps relating to the same securitisation is equal to the greatest loss the firm would suffer in the scenarios set out in the matrix in BIPRU 7.11.43 R. Each scenario consists of the combination of one of the nine scenarios on the vertical axis with one of the three scenarios on the horizontal axis.

2. (2)

   T as referred to in that matrix is the amount set out in the table in BIPRU 7.11.44 R.

3. (3)

   Stresses (1) - (4) as referred to in that matrix are further defined in BIPRU 7.11.45 R - BIPRU 7.11.46 R.

4. (4)

   The underlying reference entities referred to in that matrix refer to the obligor under the securities that are the subject of the securitisation in question. In the case of a resecuritisation the reference entities are the ultimate underling obligors (the obligors under the securitised securitisation).

5. (5)

   The valuation change under this rule is applied to the current value of the credit default swap.

References in the table in BIPRU 7.11.43 R to credit quality steps are to the credit quality steps that would apply under the standardised approach to credit risk to the securities referred to in BIPRU 7.11.41 R (4). If a rating from an eligible ECAI is not available to the firm it must treat that security as having the lowest credit quality step.

1. (1)

   This rule explains how the correlation calculations in the vertical axis of the matrix in BIPRU 7.11.43 R are to be carried out.

2. (2)

   The firm must calculate the base correlation relating to each of the deemed tranches set out in the table in BIPRU 7.11.46 R. Base correlation refers, in relation to a securitisation position, to the correlation in credit risk between the securities that are the subject of that securitisation.

3. (3)

   The firm must then multiply the base correlation for each deemed tranche under (2) by the relevant figure in the table in BIPRU 7.11.46 R. It must calculate each such base correlation in the way that a person would use to calculate the fair market value of a credit default swap on the following basis:

   1. (a)

      the tranche is the most junior tranche; and

   2. (b)

      the thickness of the tranche (as referred to in BIPRU 9 (Securitisation)) is equal to the percentage figure at the head of the relevant column in the table in BIPRU 7.11.46 R.

4. (4)

   The firm must then produce a stressed base correlation curve through the use of interpolation based on the calculations under this rule.

5. (5)

   Notwithstanding (3), the curve in (4) must not show a correlation above 100%.

6. (6)

   The firm must then use the curve for the purpose of the revaluation of the credit default swap under BIPRU 7.11.41 R using an appropriate and prudent technique.

The default charge for a firm's position in a securitisation treated under the securitisation credit default swap PRR method is equal to the default charge for that position calculated under BIPRU 7.11.50 R and BIPRU 7.11.51 R. The total default charge for positions treated under the securitisation credit default swap PRR method is equal to the sum of those figures.

To the extent that a firm has a matching long and short position in the same tranche of the same securitisation with the same maturity it may net the short and long positions.

If a position is short, the default charge for that position is zero.

If a position is long, the default charge for that position must be calculated in accordance with the following formula:

V x RW x AP2

where:

1. (1)

   V means the notional amount of the position;

2. (2)

   RW means the risk weight that the position would attract under BIPRU 9 (Securitisation); and

3. (3)

   AP means the appropriate percentage from the table BIPRU 7.11.52 R.

1. (1)

   The column of the table in BIPRU 7.11.52 R headed "Trades based on an index" applies if:

   1. (a)

      the position is not a resecuritisation position;

   2. (b)

      the underlying reference entities (as defined in BIPRU 7.11.41 R (4)) are identical to those that make up an index of entities widely used by those who deal in credit default swaps;

   3. (c)

      that index contains the price for entering into a credit default swap whose reference entities constitute all the entities in the index; and

   4. (d)

      the credit default swap is constructed in such a way that the firm is able to price the credit derivative using the index.

2. (2)

   The column of the table in BIPRU 7.11.52 R headed "Other" applies to any case not covered by the other two categories in the table.

BIPRU 7.11.55 R - BIPRU 7.11.58 R apply to each of the credit default swap PRR methods.

The spread referred to in the tables in BIPRU 7.11.34 R and BIPRU 7.11.43 R refers to the premia and other cash flows referred to in BIPRU 7.11.5 R (expressed as a percentage). The spread must be calculated every business day. It is the spread that would apply if the credit default swap in question were entered into on that day on arm's length commercial terms.

Where a credit default swap PRR method requires netting between positions, a firm may only net positions arising out of credit default swaps that have comparable deliverable obligations, identical credit events and documentation that will act identically on the occurrence of a credit event.

A notional position in a zero-specific-risk security created under BIPRU 7.11.5 R must not be treated under either credit default swap PRR method. The firm must instead treat it in accordance with the other rules for the calculation of the interest rate PRR.

1. (1)

   If the size of the maximum credit event payment under a credit default swap is lower than the PRR requirement that would otherwise apply, that credit default swap must be excluded from the credit default swap PRR methods. However BIPRU 7.11.19 R and BIPRU 7.11.21 R still apply.

2. (2)

   A firm must work out whether (1) applies to a credit default swap by calculating the PRR for that credit default swap in accordance with this section (including the applicable credit default swap PRR method) on the assumption that it is the only item for which an interest rate PRR is being calculated.

A firm must be able to describe, demonstrate and explain to the FSA its trading strategies in relation to credit derivatives both in theory and in practice.