Capital Adequacy Requirements (CAR) Chapter 7 – Settlement and Counterparty Risk

Document Properties

• Type of Publication: Guideline
• Effective Date: February 2023 / April 2023^{Footnote 1}
• Audiences: Banks / BHC / T&L

The Capital Adequacy Requirements (CAR) for banks (including federal credit unions), bank holding companies, federally regulated trust companies, federally regulated loan companies and cooperative retail associations, collectively referred to as 'institutions', are set out in nine chapters, each of which has been issued as a separate document. This document, Chapter 7 – Settlement and Counterparty Risk, should be read in conjunction with the other CAR chapters which include:

• Chapter 1 - Overview
• Chapter 2 - Definition of Capital
• Chapter 3 - Operational Risk
• Chapter 4 - Credit Risk – Standardized Approach
• Chapter 5 - Credit Risk – Internal Ratings Based Approach
• Chapter 6 - Securitization
• Chapter 7 - Settlement and Counterparty Risk
• Chapter 8 - Credit Valuation Adjustment (CVA) Risk
• Chapter 9 - Market Risk

Chapter 7 - Settlement and Counterparty Risk

1. This chapter is drawn from the Basel Committee on Banking Supervision (BCBS) Basel framework, published on the BIS website^{Footnote 2}, effective December 15, 2019. For reference, the Basel paragraph numbers that are associated with the text appearing in this chapter are indicated in square brackets at the end of each paragraph^{Footnote 3}.

7.1. Treatment of counterparty credit risk and cross-product netting

2. This rule identifies permissible methods for estimating the Exposure at Default (EAD) or the exposure amount for instruments with counterparty credit risk under this guideline.^{Footnote 4} Institutions may seek OSFI approval to make use of an Internal Modelling Method (IMM) meeting the requirements and specifications identified herein. As an alternative institutions may also use the Standardized Approach for Counterparty Credit Risk (SA-CCR). [Basel Framework, CRE 53.1]

7.1.1 Definitions and general terminology

3. This section defines terms that will be used throughout this chapter.

7.1.1.1 General terms

• Counterparty Credit Risk (CCR) is the risk that the counterparty to a transaction could default before the final settlement of the transaction's cash flows. An economic loss would occur if the transactions or portfolio of transactions with the counterparty has a positive economic value at the time of default. Unlike an institution's exposure to credit risk through a loan, where the exposure to credit risk is unilateral and only the lending institution faces the risk of loss, CCR creates a bilateral risk of loss: the market value of the transaction can be positive or negative to either counterparty to the transaction. The market value is uncertain and can vary over time with the movement of underlying market factors.

• A central counterparty (CCP) is a clearing house that interposes itself between counterparties to contracts traded in one or more financial markets, becoming the buyer to every seller and the seller to every buyer and thereby ensuring the future performance of open contracts. A CCP becomes a counterparty to trades with market participants through novation, an open offer system, or another legally binding arrangement. For the purposes of the capital framework, a CCP is a financial institution.

• A qualifying central counterparty (QCCP) is an entity that is licensed to operate as a CCP (including a license granted by way of confirming an exemption), and is permitted by the appropriate regulator/overseer to operate as such with respect to the products offered. This is subject to the provision that the CCP is based and prudentially supervised in a jurisdiction where the relevant regulator/overseer has established, and publicly indicated that it applies to the CCP on an on-going basis, domestic rules and regulations that are consistent with the CPSS-IOSCO Principles for Financial Market Infrastructures.

  Where the CCP is in a jurisdiction that does not have a CCP regulator applying the Principles to the CCP, then OSFI may make the determination of whether the CCP meets this definition.

  In addition, for a CCP to be considered as a QCCP, the requirements in paragraph 204 must be met to permit each clearing member institution to calculate its capital requirement for its default fund contributions.

• A clearing member is a member of, or a direct participant in, a CCP that is entitled to enter into a transaction with the CCP, regardless of whether it enters into trades with a CCP for its own hedging, investment or speculative purposes or whether it also enters into trades as a financial intermediary between the CCP and other market participants^{Footnote 5}.

• A client is a party to a transaction with a CCP through either a clearing member acting as a financial intermediary, or a clearing member guaranteeing the performance of the client to the CCP.

• Initial margin means a clearing member's or client's funded collateral posted to the CCP to mitigate the potential future exposure of the CCP to the clearing member arising from the possible future change in the value of their transactions. For the purposes of the calculation of counterparty credit risk capital requirements, initial margin does not include contributions to a CCP for mutualized loss sharing arrangements (i.e., in case a CCP uses initial margin to mutualize losses among the clearing members, it will be treated as a default fund exposure). Initial margin may include excess collateral, in cases where the CCP may prevent the clearing member and the clearing member may prevent the client from withdrawing the excess.

• Variation margin means a clearing member's or client's funded collateral posted on a daily or intraday basis to a CCP based upon price movements of their transactions.

• Trade exposures (in section 7.1.8) include the current^{Footnote 6} and potential future exposure of a clearing member or a client to a CCP arising from OTC derivatives, exchange traded derivatives transactions or securities financing transactions (SFTs), as well as initial margin.

• Default funds, also known as clearing deposits or guaranty fund contributions (or any other names), are clearing members' funded or unfunded contributions towards, or underwriting of, a CCP's mutualized loss sharing arrangements. The description given by a CCP to its mutualized loss sharing arrangements is not determinative of its status as a default fund; rather, the substance of such arrangements will govern its status.

• Offsetting transaction means the transaction leg between the clearing member and the CCP when the clearing member acts on behalf of a client (e.g. when a clearing member clears or novates a client's trade).

• A multi-level client structure is one in which institutions can centrally clear as indirect clients; that is, when clearing services are provided to the institution by an institution which is not a direct clearing member, but is itself a client of a clearing member or another clearing client. For exposures between clients and clients of clients, we use the term "higher level client" for the institution providing clearing services; and the term "lower level client" for the institution clearing through that client.

  [Basel Framework, CRE 50.6]

7.1.1.2 Transaction types

• Long Settlement Transactions are transactions where a counterparty undertakes to deliver a security, a commodity, or a foreign exchange amount against cash, other financial instruments, or commodities, or vice versa, at a settlement or delivery date that is contractually specified as more than the lower of the market standard for this particular instrument and five business days after the date on which the institution enters into the transaction.

• Securities Financing Transactions (SFTs) are transactions such as repurchase agreements, reverse repurchase agreements, security lending and borrowing, and margin lending transactions, where the value of the transactions depends on market valuations and the transactions are often subject to margin agreements.

• Margin Lending Transactions are transactions in which an institution extends credit in connection with the purchase, sale, carrying or trading of securities. Margin lending transactions do not include other loans that happen to be secured by securities collateral. Generally, in margin lending transactions, the loan amount is collateralised by securities whose value is greater than the amount of the loan.

  [Basel Framework, CRE 50.14]

7.1.1.3 Netting sets, hedging sets, and related terms

• Netting Set is a group of transactions with a single counterparty that are subject to a legally enforceable bilateral netting arrangement and for which netting is recognised for regulatory capital purposes under chapter 4 or the Cross-Product Netting Rules set forth in this chapter. Each transaction that is not subject to a legally enforceable bilateral netting arrangement that is recognised for regulatory capital purposes should be interpreted as its own netting set for the purpose of these rules.

• Hedging Set is a set of transactions within a single netting set within which full or partial offsetting is recognized for purposes of calculating the potential future exposure (PFE) add-on of the SA-CCR.

• Margin Agreement is a contractual agreement or provisions to an agreement under which one counterparty must supply collateral to a second counterparty when an exposure of that second counterparty to the first counterparty exceeds a specified level.

• Margin Threshold is the largest amount of an exposure that remains outstanding until one party has the right to call for collateral.

• Margin Period of Risk is the time period from the last exchange of collateral covering a netting set of transactions with a defaulting counterpart until that counterpart is closed out and the resulting market risk is re-hedged.

• Effective Maturity under the Internal Model Method for a netting set with maturity greater than one year is the ratio of the sum of expected exposure over the life of the transactions in a netting set discounted at the risk-free rate of return divided by the sum of expected exposure over one year in a netting set discounted at the risk-free rate. This effective maturity may be adjusted to reflect rollover risk by replacing expected exposure with effective expected exposure for forecasting horizons under one year. The formula is given in paragraph 35.

• Cross-Product Netting refers to the inclusion of transactions of different product categories within the same netting set pursuant to the Cross-Product Netting Rules set out in this chapter.

• Current Market Value (CMV) refers to the net market value of the portfolio of transactions within the netting set with the counterparty. Both positive and negative market values are used in computing CMV.

  [ Basel Framework, CRE 50.15]

7.1.1.4 Distributions

• Distribution of Market Values is the forecast of the probability distribution of net market values of transactions within a netting set for some future date (the forecasting horizon) given the realised market value of those transactions up to the present time.

• Distribution of Exposures is the forecast of the probability distribution of market values that is generated by setting forecast instances of negative net market values equal to zero (this takes account of the fact that, when the institution owes the counterparty money, the institution does not have an exposure to the counterparty).

• Risk-Neutral Distribution is a distribution of market values or exposures at a future time period where the distribution is calculated using market implied values such as implied volatilities.

• Actual Distribution is a distribution of market values or exposures at a future time period where the distribution is calculated using historic or realised values such as volatilities calculated using past price or rate changes.

  [Basel Framework, CRE 50.22 to 50.25]

7.1.1.5 Exposure measures and adjustments

• Current Exposure is the larger of zero, or the market value of a transaction or portfolio of transactions within a netting set with a counterparty that would be lost upon the default of the counterparty, assuming no recovery on the value of those transactions in bankruptcy. Current exposure is often also called Replacement Cost.

• Peak Exposure is a high percentile (typically 95% or 99%) of the distribution of exposures at any particular future date before the maturity date of the longest transaction in the netting set. A peak exposure value is typically generated for many future dates up until the longest maturity date of transactions in the netting set.

• Expected Exposure is the mean (average) of the distribution of exposures at any particular future date before the longest-maturity transaction in the netting set matures. An expected exposure value is typically generated for many future dates up until the longest maturity date of transactions in the netting set.

• Effective Expected Exposure at a specific date is the maximum expected exposure that occurs at that date or any prior date. Alternatively, it may be defined for a specific date as the greater of the expected exposure at that date, or the effective exposure at the previous date. In effect, the Effective Expected Exposure is the Expected Exposure that is constrained to be non-decreasing over time.

• Expected Positive Exposure (EPE) is the weighted average over time of expected exposures where the weights are the proportion that an individual expected exposure represents of the entire time interval. When calculating the minimum capital requirement, the average is taken over the first year or, if all the contracts in the netting set mature before one year, over the time period of the longest-maturity contract in the netting set.

• Effective Expected Positive Exposure (Effective EPE) is the weighted average over time of effective expected exposure over the first year, or, if all the contracts in the netting set mature before one year, over the time period of the longest-maturity contract in the netting set where the weights are the proportion that an individual expected exposure represents of the entire time interval.

• Credit Valuation Adjustment is an adjustment to the mid-market valuation of the portfolio of trades with a counterparty. This adjustment reflects the market value of the credit risk due to any failure to perform on contractual agreements with a counterparty. This adjustment may reflect the market value of the credit risk of the counterparty or the market value of the credit risk of both the institution and the counterparty.

• One-Sided Credit Valuation Adjustment is a credit valuation adjustment that reflects the market value of the credit risk of the counterparty to the firm, but does not reflect the market value of the credit risk of the institution to the counterparty.

• Debit Valuation Adjustment is a valuation adjustment that reflects the market value of the credit risk of the institution to the counterparty (i.e., changes in the reporting institution's own credit risk), but does not reflect the market value of the credit risk of the counterparty to the institution. [Added by OSFI]

  [Basel Framework, CRE 50.26 to 50.33]

7.1.1.6 CCR-related risks

• Rollover Risk is the amount by which expected positive exposure is understated when future transactions with a counterpart are expected to be conducted on an ongoing basis, but the additional exposure generated by those future transactions is not included in calculation of expected positive exposure.

• General Wrong-Way Risk arises when the probability of default of counterparties is positively correlated with general market risk factors.

• Specific Wrong-Way Risk arises when the exposure to a particular counterpart is positively correlated with the probability of default of the counterparty due to the nature of the transactions with the counterparty.

  [Basel Framework, CRE 50.34 to 50.36]

7.1.2 Scope of application

4. Banks must calculate a counterparty credit risk charge for all exposures that give rise to counterparty credit risk, with the exception of those transactions listed in paragraphs 10 and 11 below. The categories of transaction that give rise to counterparty credit risk are:

   • OTC Derivatives;

   • Exchange-traded derivatives (ETDs);

   • Long Settlement transactions; and

   • Securities Financing Transactions (SFTs).

   [Basel Framework, CRE 51.4]

5. Such instruments generally exhibit the following abstract characteristics:

   • the transactions generate a current exposure or market value;

   • the transactions have an associated random future market value based on market variables;

   • the transactions generate an exchange of future payments or an exchange of a financial instrument (including commodities) against payment;

   • the transactions are undertaken with an identified counterparty against which a unique probability of default can be determined.^{Footnote 7}

   [Basel Framework, CRE 51.5]

6. Other common characteristics of the transactions to be covered may include the following:

   • collateral may be used to mitigate risk exposure and is inherent in the nature of some transactions;

   • short-term financing may be a primary objective in that the transactions mostly consist of an exchange of one asset for another (cash or securities) for a relatively short period of time, usually for the business purpose of financing. The two sides of the transactions are not the result of separate decisions but form an indivisible whole to accomplish a defined objective;

   • netting may be used to mitigate the risk;

   • positions are frequently valued (most commonly on a daily basis), according to market variables.

   • remargining may be employed.

   [Basel Framework, CRE 51.6]

7.1.3 Methods for Computing CCR Exposure

7. For the transaction types listed in paragraph 4 above, banks must calculate their counterparty credit risk exposure, or exposure at default (EAD)^{Footnote 8}, using one of the methods set out in paragraphs 8 to 9 below. The methods vary according to the type of the transaction, the counterparty to the transaction, and whether the bank has received supervisory approval to use the method (if such approval is required). [Basel Framework, CRE 51.7]

8. For exposures that are not cleared through a central counterparty (CCP) the following methods must be used to calculate the counterparty credit risk exposure:

   1. The standardised approach for measuring counterparty credit risk exposures (SA-CCR), which is set out in section 7.1.7. This method is to be used for exposures arising from OTC derivatives, exchange-traded derivatives and long settlement transactions. This method must be used if the bank does not have approval to use the internal model method (IMM).

   2. The simple approach or comprehensive approach to the recognition of collateral, which are both set out in the credit risk mitigation section of the standardised approach to credit risk (see Chapter 4, section 4.3). These methods are to be used for securities financing transactions (SFTs) and must be used if the bank does not have approval to use the value-at-risk (VaR) models or the IMM.

   3. The VaR models approach, which is set out in Chapter 4, section 4.3. The VaR models approach may be used to calculate EAD for SFTs, subject to supervisory approval, as an alternative to the method set out in (2) above.

   4. The IMM, which is set out in 7.1.5. This method may be used, subject to supervisory approval, as an alternative to the methods to calculate counterparty credit risk exposures set out in (1) and (2) above (for all of the exposures referenced in those bullets).

   [Basel Framework, CRE 51.8]

9. For exposures that are cleared through a CCP, banks must apply the method set out in section 7.1.8. This method covers:

   1. the exposures of a bank to a CCP when the bank is a clearing member of the CCP;

   2. the exposures of a bank to its clients, when the bank is a clearing member and acts as an intermediary between the client and the CCP; and

   3. the exposures of a bank to a clearing member of a CCP, when the bank is a client of the clearing member and the clearing member is acting as an intermediary between the bank and the CCP.

   [Basel Framework, CRE 51.8]

10. Exposures arising from the settlement of cash transactions (equities, fixed income, spot FX and spot commodities) are not subject to this treatment^{Footnote 9}. The settlement of cash transactions remains subject to the treatment described in section 7.2. [Basel Framework, CRE 51.10]

11. As an exception to the requirements of paragraph 4 above, banks are not required to calculate a counterparty credit risk charge for the following types of transactions (i.e. the exposure amount or EAD for counterparty credit risk for the transaction will be zero):

    1. Credit derivative protection purchased by the bank against a banking book exposure, or against a counterparty credit risk exposure. In such cases, the bank will determine its capital requirement for the hedged exposure according to the criteria and general rules for the recognition of credit derivatives within the standardised approach or IRB approach to credit risk (i.e. substitution approach).

    2. Sold credit default swaps in the banking book where they are treated in the framework as a guarantee provided by the bank and subject to a credit risk charge for the full notional amount.

    [Basel Framework, CRE 51.16]

12. Under the methods outlined above, the exposure amount or EAD for a given counterparty is equal to the sum of the exposure amounts or EADs calculated for each netting set with that counterparty^{Footnote 10}, subject to the exception outlined in paragraph 13. [Basel Framework, CRE 51.11]

13. The exposure or EAD for a given OTC derivative counterparty is defined as the greater of zero, and the difference between the following: the sum of EADs across all netting sets with the counterparty, and the credit valuation adjustment (CVA) for that counterparty which has already been recognised by the bank as an incurred write-down (i.e. a CVA loss). This CVA loss is calculated without taking into account any offsetting debit valuation adjustments or funding valuation adjustments deducted from capital under Chapter 2 of this Guideline. This reduction of EAD by incurred CVA losses does not apply to the determination of the CVA risk capital requirement. [Basel Framework, CRE 51.13]

14. RWAs for a given OTC derivative counterparty may be calculated as the applicable risk weight under the Standardised or IRB approach multiplied by the outstanding EAD of the counterparty.[Basel Framework, CRE 51.12]

7.1.4 Approval to adopt an internal modelling method to estimate EAD

15. An institution (meaning the individual legal entity or a group) that wishes to adopt an internal modelling method to measure exposure or EAD for regulatory capital purposes must seek OSFI approval. IMM is available both for institutions that adopt the internal ratings-based approach to credit risk and for institutions for which the standardised approach to credit risk applies to all of their credit risk exposures. Only institutions subject to the market risk rules of Chapter 9 of this Guideline are permitted to apply for the use of the IMM. The institution must meet all of the requirements given in section 7.1.5. [Basel Framework, CRE 53.1]

16. An institution may also choose to adopt an internal modelling method to measure CCR for regulatory capital purposes for its exposures or EAD to only OTC derivatives, to only SFTs, or to both, subject to the appropriate recognition of netting specified below in section 7.1.6. The institution must apply the method to all relevant exposures within that category, except for those that are immaterial in size and risk. During the initial implementation of the internal models method, an institution may use the SACCR for a portion of its business. The institution must submit a plan to OSFI to bring all material exposures for that category of transactions under the IMM. [Basel Framework, CRE 53.2]

17. For all OTC deriva