A loan secured by financial collateral is granted to an obligor in a certain currency (e.g. EUR) while the financial collateral is denominated in another currency (e.g. USD). Such collateral covers 100% of the loan exposure at the granting date. Besides, a cross-currency swap is contracted between the obligor and the lending institution, and the proceeds of the swap is pledged by the obligor to the lending institution (on top of loan collateral being pledged to the lending institution). 

In details, the lending institution enters into a cross-currency swap with the obligor at the loan granting date, whereby the lending institution will pay EUR rate and receive USD rate, for the same maturity and notional than the ones of the loan. 

A legal assignment (equivalent to a pledge) of the cross-currency swap receivables ensures that in case of default of the obligor, when the swap mark-to-market (MtM) is in favour of the obligor (USD has depreciated), the lending institution remains the only perceiver of the swap MtM (instead of the obligor in the usual case with no swap proceeds legal assignment). In the case where the swap MtM is in favour of the lending institution (USD has appreciated), the obligor remains in any case the one paying the MtM. 

For illustrative purpose, let us consider a loan of 100 EUR secured with collateral value of 100 USD (euro-dollar parity at granting date). The risk related to currency mismatch materializes only if the USD depreciates, thus leading to a decrease of the USD collateral value to 80 EUR equivalent. At the same time, such depreciation creates a positive MtM of 20 EUR under the cross-currency swap in favour of the obligor. However, as the proceeds of the cross-currency swap are pledged to the lending institution, the MtM equal to 20 EUR is sent to the lending institution in case of default of the obligor. In this case, the lending bank neutralises the collateral value difference induced by currency mismatch thanks to the proceeds of the cross-currency swap.

In any case, the risk of loss in loan collateral value due to an adverse variation of the exchange rate for the lending institution is covered. Thus, the collateral value on which the currency mismatch is neutralised can be assimilated to be denominated in the same currency as the lent exposure. Under article 223(1), where a collateral is denominated in a currency that differs from the currency in which the underlying exposure is denominated, institutions shall add an adjustment reflecting currency volatility. However, CRR remains silent in case this currency risk is hedged.

The substance of article 223(1) is that a collateral denominated in a different currency from the loan exposes the bank to a FX risk on the collateral and the purpose of this adjustment is to capture this risk of loss contingent to a default of the counterparty cumulated to a drop in the collateral’s currency value. If this risk of loss is perfectly neutralised by a cross-currency swap, the volatility adjustment for currency mismatch required under article 223(1) is not relevant and should not be applied.