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.

1. (1)

   When calculating the PRR of the protection seller, unless specified differently by other rules and subject to (2), 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.4

2. (2)

   When calculating the PRR of the protection seller, a firm may choose to replace the notional value of the credit derivative by the notional value adjusted for changes in the market value of the credit derivative since trade inception.4

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.

Ifan nth-to-default4 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. The specific risk charge must be based on the securitisation PRAs in BIPRU 7.2 as applicable.4

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]

A firm must calculate both the net long and the net short positions in credit derivatives by applying BIPRU 7.2.36 R and BIPRU 7.2.37 R and, where applicable, BIPRU 7.2.42A R to BIPRU 7.2.42C R or BIPRU 7.11.13 R to BIPRU 7.11.17 R.4

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)

   [deleted]4

   4

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.

The specific risk portion of the interest rate PRR for credit derivatives in the trading book4 must be calculated in accordance withBIPRU 7.2.43 R to BIPRU 7.2.46A G (Specific risk calculation), BIPRU 7.2.48A R to BIPRU 7.2.48K R (Specific risk: securitisations and re-securitisations), BIPRU 7.2.48L R (Specific risk: Correlation trading portfolio), BIPRU 7.2.49 R to BIPRU 7.2.51 G (Definition of a qualifying debt security)4 and the other provisions of BIPRU 7.11, as applicable4.

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