It is common practice for firms to manage their counterparty credit risk exposures arising from derivatives activity by entering into credit protection arrangements with third parties whereby a firm would receive cash collateral via a funded guarantee or credit derivative. Such cash collateral is used to secure present and future obligations associated with the counterparty credit risk exposure to the derivatives counterparty. The recognition of funded credit protection is particularly critical to groups as it is the primary mechanism for entities of a group to be able to benefit from the capital and liquidity support of third party group entities with access to a greater pool of resources. All funded credit protection (FCP) arrangements are typically accompanied by independent, written and reasoned legal opinions which confirm the effectiveness and enforceability of the protection in relevant jurisdictions, and to provide appropriate certainty as to the credit protection achieved.

Under IFR Art 27, which outlines the calculation of the exposure value for the purposes of computing K-TCD (Trading Counterparty Default), and which serves as a basis for computing the exposure value for K-CON (Concentration Risk) (Art 36), collateral can be used as a mitigant in computing the exposure value. However, it is not clear whether the meaning of collateral in Art 27 encompasses both (i) collateral received directly from the counterparty via a margin agreement and (ii) collateral received from a third party via an FCP arrangement. 

IFR Art 27 states that “Collateral”, as determined in IFR Art 30 can be deducted when calculating an exposure value for transactions subject to trading counterparty default. According to IFR Art 30(1), all collateral for both bilateral and cleared transactions referred to in Art 25 shall be subject to volatility adjustments. However, IFR Art 30(2), which specifically details how collateral should be valued, appears to apply only to collateral received from the counterparty to the transaction:

“2. The value of collateral shall be determined as follows:

(a) for the purposes of points (a), (e) and (g) of Article 25(1), by the amount of collateral received by the investment firm from its counterparty decreased in accordance with Table 4;

(b) for the transactions referred to in points (b), (c), (d) and (f) of Article 25(1), by the sum of the CMV of the security leg and the net amount of collateral posted or received by the investment firm […].”

It is therefore not clear whether the purpose of Art 30 is intended to apply only to collateral received from the transaction counterparty.