Context

The CRR2 SA-CCR methodology defines the calculation of the Exposure at Default (EAD) for derivative transactions. The EAD is calculated based upon the Replacement Cost (RC) and the Potential Future Exposure (PFE) taking into account the volatility of the net derivative exposure:

EAD  = 1.4 x (RC + PFE).

The CRR2 SA-CCR methodology distinguishes margined and unmargined transactions:

• For an unmargined transaction, the Replacement Cost is obtained from the Current Market Value (CMV) less the Net Independent Collateral Amount (NICA) by CRR2 Art 275(1):

RC(unmargined) = max(0, CMV - NICA). 

The Potential Future Exposure is obtained as the AddOn times the Multiplier. The AddOn represents the volatility of the derivative exposure. The supervisory volatility estimate is based upon the notional, volatility parameters by type of derivative (interest rate, FX, …) and the maturity floored at 1 year. The multiplier, between 0.05 and 1, scales down the aggregate add-on in case the net market value of all transactions in the netting agreement, net of NICA, is favorable:

              PFE(unmargined) = multiplier(unmargined) * AddOn(unmargined),

with multiplier(unmargined) = min(100%, 5% + 95% * exp( (CMV - NICA) / (2* 95% * AddOn(unmargined)) ) ) from Art 278(3).

One then obtains the resulting

EAD(unmargined) = 1.4 * (RC(unmargined) + PFE(unmargined)).

• For a margined transaction, the Replacement Cost is obtained from the Current Market Value (CMV) less the Variation Margin (VM) and less the Net Independent Collateral Amount (NICA) by CRR2 Art 275(2):

RC(margined) = max(0,  CMV – VM – NICA,  TH + MTA - NICA).

The Replacement Cost also considers the exposure resulting from Margin Thresholds (TH) and Minimum Threshold Amounts (MTA) as these could increase the Replacement Cost of a perfectly margined transaction. The Potential Future Exposure is obtained as the AddOn times the Multiplier. The AddOn represents the volatility of the derivative exposure. The supervisory volatility estimate is based upon the notional, volatility parameters by type of derivative (interest rate, FX, …) and the Margin Period of Risk. The multiplier, between 0.05 and 1, scales down the aggregate add-on in case the net market value of all transactions in the netting agreement, net of any collateral held or posted, is favorable:

                              PFE(margined) = multiplier(margined) * AddOn(margined),

with multiplier(margined)  = min(100%, 5% + 95% * exp( (CMV - VM - NICA) / (2* 95% * AddOn(margined)) ) ) from Art 278(3).

One then obtains the resulting

EAD(margined) = 1.4 * (RC(margined) + PFE(margined)).

For a margined transaction, the EAD is the lower value of the EAD(margined) and EAD(unmargined). The exposure value of a netting set subject to a contractual margin agreement shall be capped at the exposure value of the same netting set not subject to any form of margin agreement (CRR2 Art 274(3)). The motivation for this capping given in the CRE52.2, of which the CRR2 regulation is a transposition, goes as follows: “The capping of the exposure at default (EAD) at the otherwise unmargined EAD is motivated by the need to ignore exposure from a large threshold amount that would not realistically be hit by some small (or non-existent) transactions.”

                This yields the resulting

EAD = min(EAD(unmargined), EAD(margined)).

Example and problem formulation

A margined netting agreement between counterparties X and Y, where X has a negative CMV = -€1.1bn that X covered by posting VM = -€1.3bn cash collateral to Y in a variation margin (no NICA, TH or MTA: NICA=TH=MTA=0), yields a net exposure of €200m for X on counterparty Y.

This is a margined agreement and as such both the margined as unmargined calculation is performed. The corresponding AddOns are €70m for the margined case and €230m for the unmargined case (longer maturity).  The multipliers are equal to 100% and 12%, respectively.  A direct application of the CRR2 formulas yields the following EAD values:

• Margined case:                 EAD(margined) = 1.4 * (€200m + 100% * €70m) = €378m.
• Unmargined case:            EAD(unmargined) =  1.4 * (€0m + 13% * €230m) = €41m.

The final EAD can therefore be capped at €41m, which is counterintuitively well below the €200m net exposure coming from the overcollateralization. The main reason for the lower unmargined calculation stems from the fact that the €1.3bn cash collateral may be ignored according the CRR2 formula. There is no additional guidance(1) on how to calculate the EAD(unmargined) for a margined transaction in the CRR2.

However, the BCBS CRE(2) 52.10 provides some further information. It explicitly states that the unmargined calculation for one-way margin agreements should include all collateral posted (via the VM) by the bank to the counterparty in the RC and the multiplier for the PFE, i.e.,

                RC(unmargined) = max(CMV – VM – NICA, 0),  

and for the multiplier one takes into account (CMV – VM – NICA): multiplier(unmargined)  = min(100%, 5% + 95% * exp((CMV - VM - NICA) / (2* 95% * AddOn(unmargined)))). Compared to the CRR2 Art 275(1) formulation, the Variation Margin is added.

By applying this principle from BCBS guidance for the EAD(unmargined) on a margined transaction, one obtains a Replacement Cost of €200m and a multiplier of 100% that result into EAD(unmargined) = 1.4 * (€200m + 100% * €230m) = €602m. The resulting EAD is equal to the lower value of the EAD(margined) €378m and EAD(unmargined) €602m, i.e., one obtains the more intuitive value of €378m. However, the BCBS guidance is not retained in the CRR2 text. More guidance is requested on how to interpret the CRR2 rules to calculate the EAD(unmargined) for a margined transaction with collateral posting.

 

(1) Regulation (EU) 2019/876 of The European Parliament and of The Council of 20 May 2019, page 63, Art 275, “VM = the volatility-adjusted value of the net variation margin received or posted, as applicable, to the netting set on a regular basis to mitigate changes in the netting set's CMV”; and page 60, “(71) Article 272 is amended as follows: […] (c) point (12) is replaced by the following: ‘(12) ‘current market value’ or ‘CMV’ means the net market value of all the transactions within a netting set gross of any collateral held or posted where positive and negative market values are netted in computing the CMV;’ (d) the following point is inserted: ‘(12a) ‘net independent collateral amount’ or ‘NICA’ means the sum of the volatility-adjusted value of net collateral received or posted, as applicable, to the netting set other than variation margin;”.

(2) As described in the footnote 2 in the CRE 52.10. Despite the given example not being a one-way margin agreement, this footnote implies that even for unmargined calculations posted collateral should be used to correct the CMV. The CRR2 Regulation (EU) 2019/876 has defined a one-way margin agreement on page 60, though there does not seem to be any further reference to it.