# Standardized Approach for Calculating the Exposure Amount of Derivative Contracts > Briefs, arguments, decisions, and more. URL: https://www.frixlaw.com/law-library/documents/fr%3A2018-24924 ## Record - **Collection:** Federal Register - **Document type:** Proposed Rule - **Published:** December 17, 2018 - **Citation:** 83 FR 64660 ## Text DEPARTMENT OF TREASURY Office of the Comptroller of the Currency 12 CFR Parts 3 and 32 [Docket ID OCC-2018-0030] RIN 1557-AE44 FEDERAL RESERVE SYSTEM 12 CFR Part 217 [Docket R-1629] RIN 7100-AF22 FEDERAL DEPOSIT INSURANCE CORPORATION 12 CFR Part 324 RIN 3064-AE80 Standardized Approach for Calculating the Exposure Amount of Derivative Contracts AGENCY: The Board of Governors of the Federal Reserve System; the Federal Deposit Insurance Corporation; and the Office of the Comptroller of the Currency, Treasury. ACTION: Notice of proposed rulemaking. SUMMARY: The Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency (together, the agencies) are inviting public comment on a proposal that would implement a new approach for calculating the exposure amount of derivative contracts under the agencies' regulatory capital rule. The proposed approach, called the standardized approach for counterparty credit risk (SA-CCR), would replace the current exposure methodology (CEM) as an additional methodology for calculating advanced approaches total risk-weighted assets under the capital rule. An advanced approaches banking organization also would be required to use SA-CCR to calculate its standardized total risk-weighted assets; a non-advanced approaches banking organization could elect to use either CEM or SA-CCR for calculating its standardized total risk-weighted assets. In addition, the proposal would modify other aspects of the capital rule to account for the proposed implementation of SA-CCR. Specifically, the proposal would require an advanced approaches banking organization to use SA-CCR with some adjustments to determine the exposure amount of derivative contracts for calculating total leverage exposure (the denominator of the supplementary leverage ratio). The proposal also would incorporate SA-CCR into the cleared transactions framework and would make other amendments, generally with respect to cleared transactions. The proposed introduction of SA-CCR would indirectly affect the Board's single counterparty credit limit rule, along with other rules. The Office of the Comptroller of the Currency also is proposing to update cross-references to CEM and add SA-CCR as an option for determining exposure amounts for derivative contracts in its lending limit rules. DATES: Comments should be received on or before February 15, 2019. ADDRESSES: Comments should be directed to: Board: You may submit comments, identified by Docket No. [R-1629 and RIN 7100-AF22], by any of the following methods: 1. Agency Website: http://www.federalreserve.gov. Follow the instructions for submitting comments at http://www.federalreserve.gov/generalinfo/foia/ProposedRegs.cfm. 2. Email: regs.comments@federalreserve.gov. Include docket number in the subject line of the message. 3. Fax: (202) 452-3819 or (202) 452-3102. 4. Mail: Ann E. Misback, Secretary, Board of Governors of the Federal Reserve System, 20th Street and Constitution Avenue NW, Washington, DC 20551. All public comments are available from the Board's website at http://www.federalreserve.gov/generalinfo/foia/ProposedRegs.cfm as submitted, unless modified for technical reasons or to remove sensitive personal identifying information (PII) at the commenter's request. Public comments may also be viewed electronically or in paper form in Room 3515, 1801 K Street NW (between 18th and 19th Streets NW), Washington, DC 20006 between 9:00 a.m. and 5:00 p.m. on weekdays. FDIC: You may submit comments, identified by RIN 3064-AE80, by any of the following methods: • Agency Website: http://www.fdic.gov/regulations/laws/federal. Follow instructions for submitting comments on the Agency website. • Email: Comments@FDIC.gov. Include “RIN 3064-AE80” on the subject line of the message. • Mail: Robert E. Feldman, Executive Secretary, Attention: Comments/RIN 3064-AE80, Federal Deposit Insurance Corporation, 550 17th Street NW, Washington, DC 20429. • Hand Delivery/Courier: Comments may be hand delivered to the guard station at the rear of the 550 17th Street Building (located on F Street) on business days between 7 a.m. and 5 p.m. All comments received must include the agency name (FDIC) and RIN 3064-AE80 and will be posted without change to http://www.fdic.gov/regulations/laws/federal, including any personal information provided. OCC: You may submit comments to the OCC by any of the methods set forth below. Commenters are encouraged to submit comments through the Federal eRulemaking Portal or email, if possible. Please use the title “Capital Adequacy: Standardized Approach for Calculating the Exposure Amount of Derivative Contracts” to facilitate the organization and distribution of the comments. You may submit comments by any of the following methods: • Federal eRulemaking Portal—“Regulations.gov”: Go to www.regulations.gov. Enter “Docket ID OCC-2018-0030” in the Search Box and click “Search.” Click on “Comment Now” to submit public comments. • Click on the “Help” tab on the Regulations.gov home page to get information on using Regulations.gov , including instructions for submitting public comments. • Email: regs.comments@occ.treas.gov. • Mail: Legislative and Regulatory Activities Division, Office of the Comptroller of the Currency, 400 7th Street SW, suite 3E-218, Washington, DC 20219. • Hand Delivery/Courier: 400 7th Street SW, Suite 3E-218, Washington, DC 20219. Instructions: You must include “OCC” as the agency name and “Docket ID OCC-2018-0030” in your comment. In general, the OCC will enter all comments received into the docket and publish the comments on the Regulations.gov website without change, including any business or personal information that you provide such as name and address information, email addresses, or phone numbers. Comments received, including attachments and other supporting materials, are part of the public record and subject to public disclosure. Do not include any information in your comment or supporting materials that you consider confidential or inappropriate for public disclosure. You may review comments and other related materials that pertain to this rulemaking action by any of the following methods: • Viewing Comments Electronically: Go to www.regulations.gov. Enter “Docket ID OCC-2018-0030” in the Search box and click “Search.” Click on “Open Docket Folder” on the right side of the screen. Comments and supporting materials can be viewed and filtered by clicking on “View all documents and comments in this docket” and then using the filtering tools on the left side of the screen. • Click on the “Help” tab on the Regulations.gov home page to get information on using Regulations.gov . The docket may be viewed after the close of the comment period in the same manner as during the comment period. • Viewing Comments Personally: You may personally inspect comments at the OCC, 400 7th Street SW, Washington, DC 20219. For security reasons, the OCC requires that visitors make an appointment to inspect comments. You may do so by calling (202) 649-6700 or, for persons who are deaf or hearing impaired, TTY, (202) 649-5597. Upon arrival, visitors will be required to present valid government-issued photo identification and submit to security screening in order to inspect comments. FOR FURTHER INFORMATION CONTACT: Board: Constance M. Horsley, Deputy Associate Director, (202) 452-5239; David Lynch, Deputy Associate Director, (202) 452-2081; Elizabeth MacDonald, Manager, (202) 475-6316; Michael Pykhtin, Manager, (202) 912-4312; Mark Handzlik, Senior Supervisory Financial Analyst, (202) 475-6636; Sara Saab, Supervisory Financial Analyst, (202) 872-4936; or Noah Cuttler, Senior Financial Analyst, (202) 912-4678; Division of Supervision and Regulation; or Benjamin W. McDonough, Assistant General Counsel, (202) 452-2036; Mark Buresh, Counsel, (202) 452-5270; Andrew Hartlage, Counsel, (202) 452-6483; Legal Division, Board of Governors of the Federal Reserve System, 20th and C Streets NW, Washington, DC 20551. For the hearing impaired only, Telecommunication Device for the Deaf, (202) 263-4869. FDIC: Bobby R. Bean, Associate Director, bbean@fdic.gov; Irina Leonova, Senior Policy Analyst, ileonova@fdic.gov; Peter Yen, Senior Policy Analyst, pyen@fdic.gov, Capital Markets Branch, Division of Risk Management Supervision, (202) 898-6888; or Michael Phillips, Counsel, mphillips@fdic.gov; Catherine Wood, Counsel, cawood@fdic.gov; Supervision Branch, Legal Division, Federal Deposit Insurance Corporation, 550 17th Street NW, Washington, DC 20429. OCC: Guowei Zhang, Risk Expert, Capital Policy, (202) 649-7106; Kevin Korzeniewski, Counsel, (202) 649-5490; or Ron Shimabukuro, Senior Counsel, (202) 649-5490, or, for persons who are deaf or hearing impaired, TTY, (202) 649-5597, Chief Counsel's Office, Office of the Comptroller of the Currency, 400 7th Street SW, Washington, DC 20219. SUPPLEMENTARY INFORMATION: Table of Contents I. Background A. Scope and Application of the Proposed Rule B. Proposal's Interaction With Agency Requirements and Other Proposals C. Overview of Derivative Contracts D. Mechanics of the Current Exposure Methodology E. Mechanics of the Internal Models Methodology F. Review of the Capital Rule's Treatment of Derivative Contracts II. Standardized Approach for Counterparty Credit Risk A. Key Concepts 1. Netting Sets 2. Hedging Sets 3. Derivative Contract Amount for the PFE Component Calculation 4. Collateral Recognition and Differentiation Between Margined and Unmargined Derivative Contracts B. Mechanics of the Standardized Approach for Counterparty Credit Risk 1. Exposure Amount 2. Replacement Cost 3. Aggregated Amount and Hedging Set Amounts 4. PFE Multiplier 5. PFE Calculation for Nonstandard Margin Agreements 6. Adjusted Derivative Contract Amount 7. Example of Calculation III. Revisions to the Cleared Transactions Framework A. Trade Exposure Amount B. Treatment of Collateral C. Treatment of Default Fund Contributions IV. Revisions to the Supplementary Leverage Ratio V. Technical Amendments A. Receivables Due From a QCCP B. Treatment of Client Financial Collateral Held by a CCP C. Clearing Member Exposure When CCP Performance is Not Guaranteed D. Bankruptcy Remoteness of Collateral E. Adjusted Collateral Haircuts for Derivative Contracts F. OCC Revisions to Lending Limits VI. Impact of the Proposed Rule VII. Regulatory Analyses A. Paperwork Reduction Act B. Regulatory Flexibility Act C. Plain Language D. Riegle Community Development and Regulatory Improvement Act of 1994 E. OCC Unfunded Mandates Reform Act of 1995 Determination I. Background A firm with a positive exposure on a derivative contract expects to receive a payment from its counterparty and is subject to the credit risk that the counterparty will default on its obligations and fail to pay the amount owed under the derivative contract. Because of this, the regulatory capital rule (capital rule) 1 of the Board of Governors of the Federal Reserve System (Board), the Federal Deposit Insurance Corporation (FDIC), and the Office of the Comptroller of the Currency (OCC) (together, the agencies) requires a banking organization 2 to hold regulatory capital based on the exposure amount of its derivative contracts. The agencies are issuing this notice of proposed rulemaking (proposal) to implement a new approach for calculating the exposure amount of derivative contracts under the capital rule. 1 See 12 CFR part 3 (OCC); 12 CFR part 217 (Board); 12 CFR part 324 (FDIC). The agencies have codified the capital rule in different parts of title 12 of the CFR (part 3 (OCC); part 217 (Board); and part 324 (FDIC)), but the internal structure of the sections within each agency's rule are identical. All references to sections in the capital rule or the proposal are intended to refer to the corresponding sections in the capital rule of each agency. 2 Banking organizations subject to the agencies' capital rule include national banks, state member banks, insured state nonmember banks, savings associations, and top-tier bank holding companies and savings and loan holding companies domiciled in the United States, but exclude banking organizations subject to the Board's Small Bank Holding Company Policy Statement (12 CFR part 225, appendix C), and certain savings and loan holding companies that are substantially engaged in insurance underwriting or commercial activities or that are estate trusts, and bank holding companies and savings and loan holding companies that are employee stock ownership plans. As discussed in greater detail below, the capital rule prescribes different approaches to measuring the exposure amount of derivative contracts, depending on the size and complexity of the banking organization. For example, all banking organizations are required to use the current exposure methodology (CEM) to determine the exposure amount of their derivative contracts under the standardized approach of the capital rule, which is based on formulas described in the capital rule. Advanced approaches banking organizations also may use an internal models-based approach, the internal models methodology (IMM), to determine the exposure amount of their derivative contracts under the advanced approaches of the capital rule. 3 The addition of a new approach, called the standardized approach for counterparty credit risk (SA-CCR), would provide important improvements to risk-sensitivity and calibration relative to CEM, but also would provide a less complex and non-model-dependent approach than IMM. 3 A banking organization is an advanced approaches banking organization if it has at least $250 billion in total consolidated assets or if it has consolidated on-balance sheet foreign exposures of at least $10 billion, or if it is a subsidiary of a depository institution, bank holding company, savings and loan holding company or intermediate holding company that is an advanced approaches banking organization. See 12 CFR 3.100(b) (OCC); 12 CFR 217.100(b) (Board); and 12 CFR 324.100(b) (FDIC). In addition, the agencies are proposing to revise the capital rule's cleared transactions framework and the supplementary leverage ratio to accommodate the proposed implementation of SA-CCR, as well as make certain other changes to the cleared transaction framework in the capital rule. A. Scope and Application of the Proposed Rule The capital rule provides two methodologies for determining total risk-weighted assets: The standardized approach, which applies to all banking organizations, and the advanced approaches, which apply only to advanced approaches banking organizations. The standardized approach serves as a floor on advanced approaches banking organizations' total risk-weighted assets, and thus such banking organizations must calculate total risk-weighted assets under both approaches. 4 Total risk-weighted assets are the denominator of the risk-based capital ratios; regulatory capital is the numerator. 4 12 CFR 3.10(c) (OCC); 12 CFR 217.10(c) (Board); and 12 CFR 324.10(c) (FDIC). For example, an advanced approaches banking organization's tier 1 capital ratio is the lower of the ratio of the banking organization's common equity tier 1 capital to standardized total risk-weighted assets and the ratio of the banking organization's common equity tier 1 capital to advanced approaches total risk-weighted assets. Under the standardized approach, the risk-weighted asset amount for a derivative contract is the product of the exposure amount of the derivative contract and the risk weight applicable to the counterparty, as provided under the capital rule. Under the advanced approaches, the risk-weighted asset amount for a derivative contract is derived using the internal ratings-based approach, which multiplies the exposure amount (or exposure at default amount) of the derivative contract by a models-based formula that uses risk parameters determined by a banking organization's internal methodologies. 5 5 See generally 12 CFR 3.132 (OCC); 12 CFR 217.132 (Board); and 12 CFR 324.132 (FDIC). Both the standardized approach and the advanced approaches require a banking organization to determine the exposure amount for its derivative contracts that are not cleared transactions ( i.e., over-the-counter derivative contracts or noncleared derivative contracts). As part of the cleared transactions framework, both the standardized approach and the advanced approaches require a banking organization to determine the exposure amount of its derivative contracts that are cleared transactions ( i.e., cleared derivative contracts) and determine the risk-weighted asset amounts of its contributions or commitments to mutualized loss sharing agreements with central counterparties ( i.e., default fund contributions). For the advanced approaches, an advanced approaches banking organization may use either CEM or IMM to calculate the exposure amount of its noncleared and cleared derivative contracts, as well as the risk-weighted asset amounts of its default fund contributions. For purposes of determining these amounts for the standardized approach, all banking organizations must use CEM. The proposal would revise the standardized approach and the advanced approaches for advanced approaches banking organizations by replacing CEM with SA-CCR. As a result, for purposes of determining total risk-weighted assets under the advanced approaches, an advanced approaches banking organization would have the option to use SA-CCR or IMM to calculate the exposure amount of its noncleared and cleared derivative contracts, as well as to determine the risk-weighted asset amount of its default fund contributions. For purposes of determining the exposure amount of these items under the standardized approach, an advanced approaches banking organization would be required to use SA-CCR. The capital rule also requires an advanced approaches banking organization to meet a supplementary leverage ratio. The denominator of the supplementary leverage ratio, called total leverage exposure, includes the exposure amount of a banking organization's derivative contracts. The capital rule requires an advanced approaches banking organization to use CEM to determine the exposure amount of its derivative contracts for total leverage exposure. Under the proposal, an advanced approaches banking organization would be required to use SA-CCR to determine the exposure amount of its derivative contracts for total leverage exposure. As it applies to advanced approaches banking organizations, the proposed implementation of SA-CCR would provide important improvements to risk-sensitivity and calibration relative to CEM, resulting in more appropriate capital requirements for derivative contracts. SA-CCR also would be responsive to concerns raised regarding the current regulatory capital treatment for derivative contracts under CEM. For example, the industry has raised concerns that CEM does not appropriately recognize collateral, including the risk-reducing nature of variation margin, and does not provide sufficient netting for derivative contracts that share similar risk factors. The agencies intend for the proposed implementation of SA-CCR to respond to these concerns, and to be substantially consistent with international standards issued by the Basel Committee on Banking Supervision (Basel Committee). In addition, requiring an advanced approaches banking organization to use SA-CCR or IMM for all purposes under the advanced approaches would facilitate regulatory reporting and the supervisory assessment of an advanced approaches banking organization's capital management program. The proposed implementation of SA-CCR would require advanced approaches banking organizations to augment existing systems or develop new ones. Accordingly, the proposal includes a transition period, until July 1, 2020, by which time an advanced approaches banking organization must implement SA-CCR. An advanced approaches banking organization may, however, adopt SA-CCR as of the effective date of the final rule. In addition, the technical revisions in this proposal, as described in section V of this Supplementary Information, would become effective as of the effective date of the final rule. While the agencies recognize that implementation of SA-CCR offers several improvements to CEM, it also will require, particularly for banking organizations with relatively small derivatives portfolios, internal systems enhancements and other operational modifications that could be costly and present additional burden. Therefore, the proposal would not require non-advanced approaches banking organizations to use SA-CCR, but instead would provide SA-CCR as an optional approach. However, a non-advanced approaches banking organization that elects to use SA-CCR for calculating its exposure amount for noncleared derivative contracts also would be required to use SA-CCR to calculate the exposure amount for its cleared derivative contracts and for calculating the risk-weighted asset amount of its default fund contributions. This approach should provide meaningful flexibility, while promoting consistency for the regulatory capital treatment of derivative contracts for non-advanced approaches banking organizations. The proposal also would allow non-advanced approaches banking organizations to adopt SA-CCR as of the effective date of the final rule. Table 1—Scope and Applicability of the Proposed Rule Non-cleared derivative contracts Cleared transactions framework Default fund contribution Advanced approaches banking organizations, advanced approaches total risk-weighted assets Option to use SA-CCR or IMM to determine exposure amount for derivative contracts under the advanced approaches Must use the approach selected for purposes of the counterparty credit risk framework (either SA-CCR or IMM), to determine the trade exposure amount for cleared derivative contracts Must use SA-CCR for purposes of the default fund contribution included in risk-weighted assets. Advanced approaches banking organizations, standardized approach total risk-weighted assets Must use SA-CCR to determine exposure amount for derivative contracts Must use SA-CCR to determine trade exposure amount for cleared derivative contracts Must use SA-CCR for purposes of the default fund contribution included in risk-weighted assets. Non-advanced approaches banking organizations, standardized approach total risk-weighted assets Option to use CEM or SA-CCR to determine exposure amount for derivative contracts Must use the approach selected for purposes of the counterparty credit risk framework (either CEM or SA-CCR), to determine the trade exposure amount for cleared derivative contracts Must use the approach selected for purposes of the counterparty credit risk framework (either CEM or SA-CCR) for purposes of the default fund contribution included in risk-weighted assets. Advanced approaches banking organizations, supplementary leverage ratio Must use modified SA-CCR to determine the exposure amount of derivative contracts for total leverage exposure under the supplementary leverage ratio. Question 1: The agencies invite comment on all aspects of this proposal. In addition to the risk-sensitivity enhancements SA-CCR provides relative to CEM, what other considerations relevant to the determination of whether to replace CEM with SA-CCR for advanced approaches banking organizations should the agencies consider? Question 2: The agencies invite comment on the proposed effective date of SA-CCR for advanced approaches banking organizations. What alternative timing should be considered and why? B. Proposal's Interaction With Agency Requirements and Other Proposals The Board's single counterparty credit limit rule (SCCL) authorizes a banking organization subject to the SCCL to use any methodology that such a banking organization may use under the capital rule to value a derivative contract for purposes of the SCCL. 6 Thus, for valuing a derivative contract under the SCCL, the proposal would require an advanced approaches banking organization that is subject to the SCCL to use SA-CCR or IMM and would require a non-advanced approaches banking organization that is subject to the SCCL to use CEM or SA-CCR. 7 In addition, the agencies net stable funding ratio proposed rules would cross-reference provisions of the agencies' supplementary leverage ratio that are proposed to be amended in this proposal, and thus this proposal potentially could affect elements of the net stable funding ratio rulemaking. 8 6 83 FR 38460 (August 6, 2018). 7 Many of the Board's other regulations rely on amounts determined under the capital rule, and the introduction of SA-CCR therefore could indirectly effect all such rules. 8 See 81 FR 35124 (June 1, 2016). The agencies also are in the process of considering the appropriate scope of “advanced approaches banking organizations” and may propose changes to the scope of this term in the near future. The agencies anticipate that the proposal on the scope of “advanced approaches banking organizations” would have an overlapping comment period with this proposal. Commenters should consider both proposals together for purposes of their comments to the agencies. C. Overview of Derivative Contracts In general, derivative contracts represent agreements between parties either to make or receive payments or to buy or sell an underlying asset on a certain date (or dates) in the future. Parties generally use derivative contracts to mitigate risk, although nonhedging use of derivative contracts also occurs. For example, an interest rate derivative contract allows a party to manage the risk associated with a change in interest rates, while a commodity derivative contract allows a party to lock in commodity prices in the future and thereby minimize any exposure attributable to any uncertainty with respect to subsequent movements in those prices. The value of a derivative contract, and thus a party's exposure to its counterparty, changes over the life of the contract based on movements in the value of the reference rates, assets, or indices underlying the contract. A party with a positive current exposure expects to receive a payment or other beneficial transfer from the counterparty and is considered to be “in the money.” A party that is in the money is subject to counterparty credit risk: The risk that the counterparty will default on its obligations and fail to pay the amount owed under the transaction. In contrast, a party with a zero or negative current exposure does not expect to receive a payment or beneficial transfer from the counterparty and is considered to be “at the money” or “out of the money.” A party that has no current exposure to counterparty credit risk may have exposure to counterparty credit risk in the future if the derivative contract becomes “in the money.” To mitigate the counterparty credit risk of a derivative contract, parties typically exchange collateral. In the derivatives context, collateral is either variation margin or initial margin (also known as independent collateral). Parties exchange variation margin on a periodic basis during the term of a derivative contract, as typically specified in a variation margin agreement or by regulation. 9 Variation margin offsets changes in the market value of a derivative contract and thereby covers the potential loss arising from default of a counterparty. Variation margin may not always be sufficient to cover a party's positive exposure ( e.g., due to delays in receiving collateral), and thus parties may exchange initial margin. Parties typically exchange initial margin at the outset of the derivative contract and usually in an amount that does not directly depend on changes in the value of the derivative contract. Parties typically post initial margin in amounts that would reduce the likelihood of a positive exposure amount for the derivative contract in the event of the counterparty's default, resulting in overcollateralization. 9 See, e.g., Swap Margin Rule, 12 CFR part 45 (OCC); 12 CFR part 237 (Board); 12 CFR part 349 (FDIC). To facilitate the exchange of collateral, variation margin agreements typically provide for a threshold amount and a minimum transfer amount. The threshold amount is the amount by which the market value of the derivative contract can change before a party must collect or post variation margin (in other words, the threshold amount specifies an acceptable amount of under-collateralization). The minimum transfer amount is the smallest amount of collateral that a party must transfer when it is required to exchange collateral under the variation margin agreement. Parties generally apply a discount (also known as a haircut) to collateral to account for a potential reduction in the value of the collateral during the period between the last exchange of collateral before the close out of the derivative contract (as in the case of default of the counterparty) and the replacement of the contract on the market. This period is known as the margin period of risk (MPOR). Often, two parties will enter into a large number of derivative contracts together. In such cases, the parties may enter into a netting agreement to allow for offsetting of the derivative contracts and to streamline certain aspects of the contracts, including the exchange of collateral. Parties to a derivative contract may clear their derivative contracts through a central counterparty (CCP). The use of central clearing is designed to improve the safety and soundness of the derivatives markets through the multilateral netting of exposures, establishment and enforcement of collateral requirements, and the promotion of market transparency. A party engages with a CCP either as a clearing member or as a clearing member client. A clearing member is a member of, or direct participant in, a CCP that is entitled to enter into transactions with the CCP. A clearing member client is a party to a cleared transaction associated with a CCP in which a clearing member acts as a financial intermediary with respect to the clearing member client and either takes one position with the client and an offsetting position with the CCP (the principal model) or guarantees the performance of the clearing member client to the CCP (the agency model). With respect to the latter, the clearing member generally is responsible for fulfilling CCP initial and variation margin calls irrespective of the client's ability to post collateral. D. Mechanics of the Current Exposure Methodology Under CEM, the exposure amount of a single derivative contract is equal to the sum of its current credit exposure and potential future exposure (PFE). 10 Current credit exposure reflects a banking organization's current exposure to its counterparty and is equal to the greater of zero and the on-balance sheet fair value of the derivative contract. 11 PFE approximates the banking organization's potential exposure to its counterparty over the remaining maturity of the derivative contract. PFE equals the product of the notional amount of the derivative contract and a supervisory-provided conversion factor, which reflects the potential volatility in the reference asset for the derivative contract. 12 The capital rule gives the supervisory-provided conversion factors via a simple look-up table, based on the derivative contract's type and remaining maturity. 13 In general, potential exposure increases as volatility and duration of the derivative contract increases. 10 See 12 CFR 3.34 (OCC); 12 CFR 217.34 (Board); 12 CFR 324.34 (FDIC). 11 12 CFR 3.34(a)(1)(i) (OCC); 12 CFR 217.34(a)(1)(i) (Board); 12 CFR 324.34(a)(1)(i) (FDIC). 12 12 CFR 3.34(a)(1)(ii) (OCC); 12 CFR 217.34(a)(1)(ii) (Board); 12 CFR 324.34(a)(1)(ii) (FDIC). 13 12 CFR 3.34, Table 1 to § 3.34 (OCC); 12 CFR 217.34, Table 1 to § 217.34 (Board); 12 CFR 324.34, Table 1 to § 324.34 (FDIC). The derivative contract types are interest rate, exchange rate, investment grade credit, non-investment grade credit, equity, gold, precious metals except gold, and other. The maturities are one year or less, greater than one year and less than or equal to five years, and greater than five years. If certain criteria are met, CEM allows a banking organization to measure the exposure amount of a portfolio of its derivative contracts with a counterparty on a net basis, rather than on a gross basis, resulting in a lower measure of exposure and thus a lower capital requirement. A banking organization may measure, on a net basis, derivative contracts that are subject to the same qualifying master netting agreement (QMNA). A QMNA, in general, means a netting agreement that permits a banking organization to terminate, close-out on a net basis, and promptly liquidate or set off collateral upon an event of default of the counterparty. 14 To qualify as a QMNA, the netting agreement must satisfy certain operational requirements under § _.3 of the capital rule. 15 14 See 12 CFR 3.2 (OCC); 12 CFR 217.2 (Board); and 12 CFR 324.2 (FDIC). In 2017, the agencies adopted a final rule that requires U.S. global systemically important banking institutions (GSIBs) and the U.S. operations of foreign GSIBs to amend their qualified financial contracts to prevent their immediate cancellation or termination if such a firm enters bankruptcy or a resolution process. Qualified financial contracts include derivative contracts, securities lending, and short-term funding transactions such as repurchase agreements. The 2017 rulemaking would have invalidated the ability of derivative contracts to be subject to a QMNA. Therefore, as part of the 2017 rulemaking, the agencies revised the definition of QMNA under the capital rule such that qualified financial contracts could be subject to a QMNA (notwithstanding other operational requirements). See 82 FR 42882 (September 2017). 15 See Definition of “qualifying master netting agreement,” 12 CFR 3.3 (OCC); 12 CFR 217.3 (Board); and 12 CFR 324.3 (FDIC). For derivative contracts subject to a QMNA, the exposure amount equals the sum of the net current credit exposure and the adjusted sum of the PFE amounts of the derivative contracts. 16 The net current credit exposure is the greater of the net sum of all positive and negative fair values of the individual derivative contracts subject to the QMNA or zero. 17 Thus, derivative contracts that have positive and negative fair values can offset each other to reduce the net current credit exposure, subject to a floor of zero. The adjusted sum of the PFE amount component provides the netting function, and is a function of the gross PFE amount of the derivative contracts and the net-to-gross ratio. The gross PFE amount is the sum of the PFE of each derivative contract subject to the QMNA. The net-to-gross ratio is the ratio of the net current credit exposure of each derivative contract subject to the QMNA to the sum of the positive current credit exposure of these derivative contracts. Specifically, the adjusted sum of the PFE amounts equals the sum of (1) the gross PFE amount multiplied by 0.4 and (2) the gross PFE amount multiplied by the net-to-gross ratio and 0.6. 18 Thus, as the net-to-gross ratio decreases so will the adjusted sum of the PFE amounts. 16 12 CFR 3.34(a)(2) (OCC); 12 CFR 217.34(a)(2) (Board); 12 CFR 324.34(a)(2) (FDIC). 17 12 CFR 3.34(a)(2)(i) (OCC); 12 CFR 217.34(a)(2)(i) (Board); 12 CFR 324.34(a)(2)(i) (FDIC). 18 12 CFR 3.34(a)(2)(ii) (OCC); 12 CFR 217.34(a)(2)(ii) (Board); 12 CFR 324.34(a)(2)(ii) (FDIC). For all derivative contracts calculated under CEM, a banking organization may recognize the credit-risk-mitigating benefits of financial collateral, pursuant to § _.37 of the capital rule. In particular, a banking organization may either apply the risk weight applicable to the collateral to the secured portion of the exposure or net exposure amounts and collateral amounts according to a regulatory formula that includes certain haircuts for collateral. 19 19 12 CFR 3.34(b) (referencing 12 CFR 3.37) (OCC); 12 CFR 217.34(b) (referencing 12 CFR 217.37) (Board); 12 CFR 324.34(b) (referencing 12 CFR 324.37) (FDIC). E. Mechanics of the Internal Models Methodology Under IMM, an advanced approaches banking organization uses its own internal models of exposure to determine the exposure amount of its derivative contracts. The exposure amount under IMM is calculated as the product of the effective expected positive exposure (EEPE) for a netting set, which is the time-weighted average of the effective expected exposures (EE) profile over a one-year horizon, and an alpha factor. 20 For the purposes of regulatory capital calculations, the resulting exposure amount is treated as a loan equivalent exposure, which is the amount effectively loaned by the banking organization to the counterparty under the derivative contract. 20 A banking organization arrives at the exposure amount by first determining the EE profile for each netting set. In general, EE profile is determined by computing exposure distributions over a set of future dates using Monte Carlo simulations, and the expectation of exposure at each date is the simple average of all Monte Carlo simulations for each date. The expiration of short-term trades can cause the EE profile to decrease, even though a banking organization is likely to replace short-term trades with new trades ( i.e., rollover). To account for rollover, a banking organization converts the EE profile for each netting set into an effective EE profile by applying a nondecreasing constraint to the corresponding EE profile over the first year. The nondecreasing constraint prevents the effective EE profile from declining with time by replacing the EE amount at a given future date with the maximum of the EE amounts across this and all prior simulation dates. The EEPE for a netting set is the time-weighted average of the effective EE profile over a one-year horizon. EEPE would be the appropriate loan equivalent exposure in a credit risk capital calculation if the following assumptions were true: There is no concentration risk, systematic market risk, and wrong-way risk ( i.e., the size of an exposure is positively correlated with the counterparty's probability of default). However, these conditions nearly never exist with respect to a derivative contract. Thus, to account for these risks, IMM requires a banking organization to multiply EEPE by 1.4. F. Review of the Capital Rule's Treatment of Derivative Contracts CEM was developed several decades ago and, as a result, does not reflect recent market conventions and regulatory requirements that are designed to reduce the risks associated with derivative contracts. 21 For banking organizations with substantial derivatives portfolios in particular, this can result in a significant mismatch between the risk posed by these portfolios and the regulatory capital that the banking organization must hold against them. For instance, CEM does not differentiate between margined and unmargined derivative contracts, and it does not function well with other regulatory requirements, including the swap margin rule, which mandates the exchange of initial margin and variation margin for specified covered swap entities. 22 In addition, the net-to-gross ratio under CEM does not recognize, in an economically meaningful way, the risk-reducing benefits of a balanced derivative portfolio ( i.e., mixed long and short positions). Further, the agencies developed the supervisory conversion factors provided under CEM prior to the 2007-2008 financial crisis and they have not been recalibrated to reflect stress volatilities observed in recent years. 21 The agencies initially adopted CEM in 1989. 54 FR 4168 (January 27, 1989) (OCC); 54 FR 4186 (January 27, 1989) (Board); 54 FR 11500 (March 21, 1989) (FDIC). The last significant update to CEM was in 1995. 60 FR 46170 (September 5, 1995). 22 See supra n. 9. Although IMM is more risk-sensitive than CEM, IMM is more complex and requires prior supervisory approval before an advanced approaches banking organization may use it. Specifically, an advanced approaches banking organization seeking to use IMM must demonstrate to its primary federal supervisor that it has established and maintains an infrastructure with risk measurement and management processes appropriate for the firm's size and level of complexity. 23 23 See 12 CFR 3.122 (OCC); 12 CFR 217.122 (Board); 12 CFR 324.122 (FDIC). For these reasons, the Basel Committee developed SA-CCR and published it as a final standard in 2014. 24 Relative to CEM, SA-CCR provides a more risk-sensitive approach to determining the replacement cost and PFE for a derivative contract. Notably, SA-CCR improves collateral recognition ( e.g., by differentiating between margined and unmargined derivative contracts); allows a banking organization to recognize meaningful, risk-reducing relationships between derivative contracts within a balanced derivative portfolio; and better captures recently observed stress volatilities among the primary risk drivers for derivative contracts. In addition, relative to IMM, SA-CCR provides a standardized, nonmodelled approach that is more accessible to banking organizations to determine the exposure amount for derivative contracts. 24 “The standardized approach for measuring counterparty credit risk exposures,” Basel Committee on Banking Supervision, March 2014 (rev. April 2014), https://www.bis.org/publ/bcbs279.pdf. See “Foundations of the standardised approach for measuring counterparty credit risk exposures” (August 2014, rev. June 2017), https://www.bis.org/publ/bcbs_wp26.pdf. II. Standardized Approach for Counterparty Credit Risk A. Key Concepts 1. Netting Sets Under SA-CCR, a banking organization would calculate the exposure amount of its derivative contracts at the netting set level. The Basel Committee standard provides that a netting set may not be subject to more than one margin agreement. Thus, a banking organization, under the Basel Committee standard, would need to calculate the exposure amount at the level of each margin agreement and not at the level of each QMNA, regardless whether multiple margin agreements are under the same QMNA. The agencies recognize, however, that the Basel Committee standard does not reflect current industry practice and regulatory requirements, in which QMNAs often cover multiple margin agreements to order to reduce credit risk by increasing the net settlement of derivative contracts. Accordingly, and as with CEM, the proposal would allow a banking organization to calculate the exposure amount of multiple derivative contracts under the same netting set so long as each derivative contract is subject to the same QMNA. For purposes of SA-CCR, a derivative contract that is not subject to a QMNA would comprise a netting set of one derivative contract. Thus, the proposal would define a netting set to mean either one derivative contract between a banking organization and a single counterparty, or a group of derivative contracts between a banking organization and a single counterparty that are subject to a QMNA. The proposal would retain the capital rule's current definition of a QMNA. 2. Hedging Sets For the PFE calculation under SA-CCR, a banking organization would fully or partially net derivative contracts within the same netting set that share similar risk factors. This approach would recognize that derivative contracts with similar risk factors share economically meaningful relationships ( i.e., are more tightly correlated) and thus netting would be appropriate. In contrast, CEM recognizes only 60 percent of the netting benefits of derivative contracts subject to a QMNA, without accounting for relationships between derivative contracts' underlying risk factors. To effectuate this approach, the proposal would introduce the concept of hedging sets, which would generally mean those derivative contracts within the same netting set that share similar risk factors. The proposal would define five types of hedging sets—interest rate, exchange rate, credit, equity, and commodities—and would provide formulas for netting within each hedging set. Each formula would be particular to each hedging set type and would reflect regulatory correlation assumptions between risk factors in the hedging set. 3. Derivative Contract Amount for the PFE Component Calculation As with CEM, a banking organization would use an adjusted derivative contract amount for the PFE component calculation under SA-CCR. Unlike CEM, the agencies intend for the adjusted derivative contract amount under SA-CCR to reflect, in general, a conservative estimate of EEPE for a netting set composed of a single derivative contract, assuming zero fair value and zero collateral. As part of the estimate, SA-CCR would use updated supervisory factors that reflect stress volatilities observed during the financial crisis. The supervisory factors would reflect the variability of the primary risk factor of the derivative contract over a one-year horizon. In addition, SA-CCR would apply a separate maturity factor to each derivative contract that would scale down, if necessary, the default one-year risk horizon of the supervisory factor to the risk horizon appropriate for the derivative contract. A banking organization would apply a positive sign to the derivative contract amount if the derivative contract is long the risk factor and a negative sign if the derivative contract is short the risk factor. This adjustment, along with the assumption of zero fair value and zero collateral, would allow a banking organization to recognize offsetting and diversification between derivative contracts that share similar risk factors ( i.e., long and short derivative contracts within the same hedging set would be able to fully or partially offset one another). 4. Collateral Recognition and Differentiation Between Margined and Unmargined Derivative Contracts The proposal would make several improvements to the recognition of collateral under SA-CCR. The proposal would account for collateral directly within the SA-CCR exposure amount calculation, whereas under CEM a banking organization recognizes the collateral only after the exposure amount has been determined. For replacement cost, the proposal would recognize collateral on a one-for-one basis. For PFE, SA-CCR would introduce the concept of a PFE multiplier, which would allow a banking organization to reduce the PFE amount through recognition of overcollateralization, in the form of both variation margin and independent collateral, and account for negative fair value amounts of the derivative contracts within the netting set. In addition, the proposal would differentiate between margined and unmargined derivative contracts such that a netting set that is subject to a variation margin agreement (as defined in the proposal) would always have a lower or equal exposure amount than an equivalent netting set that is not subject to a variation margin agreement. B. Mechanics of the Standardized Approach for Counterparty Credit Risk 1. Exposure Amount Under § _.132(c)(5) of the proposed rule, the exposure amount of a netting set would be equal to an alpha factor of 1.4 multiplied by the sum of the replacement cost of the netting set and PFE of the netting set. The can be represented as follows: exposure amount = 1.4 * ( replacement cost + PFE ) The alpha factor was included in the Basel Committee standard under the view that a standardized approach, such as SA-CCR, should not produce lower exposure amounts than a modelled approach. Therefore, to instill a level of conservatism consistent with the Basel Committee standard, the proposal would apply an alpha factor of 1.4 in order to produce exposure measure outcomes that generally are no lower than those amounts calculated using IMM. While the estimates of PFE under SA-CCR are conservative in many cases, the estimates of the sum of the replacement cost and PFE under SA-CCR would necessarily be close to IMM's EEPE for netting sets where the replacement cost dominates PFE. 25 Thus, reducing the value of alpha in SA-CCR below 1.4 could result in exposure amounts produced by SA-CCR that are smaller than exposure amounts produced by IMM for such deep in-the-money netting sets. 25 For an unmargined netting set, IMM's EE profile starts at t=0, which is the date at which replacement cost under SA-CCR is calculated. For a deep in-the-money netting set, PFE would be much smaller than replacement cost, while IMM's EE profile would not increase significantly above replacement cost before declining (due to cash flow payments and trade expiration), because IMM volatilities typically are smaller than the volatilities implied by SA-CCR's PFE. The nondecreasing constraint would not allow the effective EE profile to drop below the replacement cost level, resulting in IMM's EEPE being slightly above replacement cost. Thus, both IMM's EEPE and SA-CCR's replacement cost plus PFE would be slightly above replacement cost and, therefore, close to each other. The exposure amount would be zero, however, for a netting set that consists only of sold options in which the counterparties to the options have paid the premiums up front and the options are not subject to a variation margin agreement. Question 3: The agencies invite comment on whether the objective of ensuring that SA-CCR produces more conservative exposure amounts than IMM is appropriate for the implementation of SA-CCR. Does the incorporation of the alpha factor support this objective, why or why not? Are there alternative measures the agencies could incorporate into SA-CCR to support this objective? Are there other objectives regarding the comparability of SA-CCR and IMM that the agencies should consider? The agencies encourage commenters to provide appropriate data or examples to support their response. 2. Replacement Cost SA-CCR would provide separate formulas for replacement cost depending on whether the counterparty to a banking organization is required to post variation margin. In general, when a banking organization is a net receiver of financial collateral, the amount of financial collateral would be positive, which would reduce replacement cost. Conversely, when the banking organization is a net provider of financial collateral, the amount of financial collateral would be negative, which would increase replacement cost. In all cases, replacement cost cannot be lower than zero. In addition, for purposes of calculating the replacement cost component (and the PFE multiplier), the fair value amount of the derivative contract would exclude any valuation adjustments. The purpose of excluding valuation adjustments is to arrive at the risk-free value of the derivative contract, and this requirement would exclude credit valuation adjustments, among other adjustments, as applicable. Section _.2 of the proposed rule provides a definition of variation margin and independent collateral, as well as the variation margin amount and the independent collateral amount. The proposal would define variation margin as financial collateral that is subject to a collateral agreement provided by one party to its counterparty to meet the performance of the first party's obligations under one or more transactions between the parties as a result of a change in value of such obligations since the last time such financial collateral was provided. Variation margin amount would mean the fair value amount of the variation margin that a counterparty to a netting set has posted to a banking organization less the fair value amount of the variation margin posted by the banking organization to the counterparty. Further, consistent with the capital rule, the amount of variation margin included in the variation margin amount would be adjusted by the standard supervisory haircuts under § _.132(b)(2)(ii) of the capital rule. The standard supervisory haircuts ensure that the derivative contract remains appropriately collateralized from a regulatory capital perspective, notwithstanding any changes in the value of the financial collateral. In particular, the standard supervisory haircuts address the possible decrease in the value of the financial collateral received by a banking organization and an increase in the value of the financial collateral posted by the banking organization over a one-year time horizon. The standard supervisory haircuts are based on a ten-business-day holding period for derivative contracts, and the capital rule requires a banking organization to adjust, as applicable, the standard supervisory haircuts to align with the risk horizon of the associated derivative contract. To be consistent with this proposal, the agencies are proposing to revise the standard supervisory haircuts so that they align with the maturity factor adjustments as provided under SA-CCR. In particular, an unmargined derivative contract and a margined derivative contract that is not a cleared transaction would receive a holding period of 10 business days. A derivative contract that is a cleared transaction would receive a holding period of five business days. 26 A banking organization would be required to use a holding period of 20 business days for collateral associated with a derivative contract that is within a netting set that is composed of more than 5,000 derivative contracts that are not cleared transactions, and if a netting set contains one or more trades involving illiquid collateral or a derivative contract that cannot be easily replaced. Notwithstanding the aforementioned, a banking organization would be required to double the applicable holding period if the derivative contract is subject to an outstanding dispute over variation margin. 26 As described in section V of this preamble, the agencies are proposing to apply a five-day holding period to all derivative contracts that are cleared transactions, regardless whether the method the banking organization uses to calculate the exposure amount of the derivative contract. The proposal would define independent collateral as financial collateral, other than variation margin, that is subject to a collateral agreement, or in which a banking organization has a perfected, first-priority security interest or, outside of the United States, the legal equivalent thereof (with the exception of cash on deposit; and notwithstanding the prior security interest of any custodial agent or any prior security interest granted to a CCP in connection with collateral posted to that CCP), and the amount of which does not change directly in response to the value of the derivative contract or contracts that the financial collateral secures. The proposal would define the net independent collateral amount as the fair value amount of the independent collateral that a counterparty to a netting set has posted to a banking organization less the fair value amount of the independent collateral posted by the banking organization to the counterparty, excluding such amounts held in a bankruptcy remote manner, 27 or posted to a qualifying central counterparty (QCCP) and held in conformance with the operational requirements in § _.3 of the capital rule. As with variation margin, independent collateral also would be subject to the standard supervisory haircuts under § _.132(b)(2)(ii) of the capital rule. 27 “Bankruptcy remote” is defined in § _.2 of the capital rule. See 12 CFR 3.2 (OCC); 12 CFR 217.2 (Board); and 12 CFR 324.2 (FDIC). Under § _.132(c)(6)(ii) of the proposed rule, the replacement cost of a netting set that is not subject to a variation margin agreement is the greater of (1) the sum of the fair values (after excluding any valuation adjustments) of the derivative contracts within the netting set, less the net independent collateral amount applicable to such derivative contracts, or (2) zero. This can be represented as follows: replacement cost = max { V − C ; 0} Where: V is the fair values (after excluding any valuation adjustments) of the derivative contracts within the netting set; and C is the net independent collateral amount applicable to such derivative contracts. The same requirement would apply to a netting set that is subject to a variation margin agreement under which the counterparty is not required to post variation margin. In the latter case, C would also include the negative amount of the variation margin that the banking organization posted to the counterparty (thus increasing replacement cost). For netting sets subject to a variation margin agreement under which the counterparty must post variation margin, the replacement cost, as provided under § _.132(c)(6)(i) of the proposed rule, would equal the greater of (1) the sum of the fair values (after excluding any valuation adjustments) of the derivative contracts within the netting set less the sum of the net independent collateral amount and the variation margin amount applicable to such derivative contracts; (2) the sum of the variation margin threshold and the minimum transfer amount applicable to the derivative contracts within the netting set less the net independent collateral amount applicable to such derivative contracts; or (3) zero. This can be represented as follows: replacement cost = max { V − C ; VMT + MTA − NICA ; 0} Where: V is the fair values (after excluding any valuation adjustments) of the derivative contracts within the netting set; VMT is the variation margin threshold applicable to the derivative contracts within the netting set; MTA is the minimum transfer amount applicable to the derivative contracts within the netting set; and C is the sum of the net independent collateral amount and the variation margin amount applicable to such derivative contracts. NICA is the net independent collateral amount applicable to such derivative contracts. The requirement for the replacement cost of a netting set subject to a variation margin agreement is designed to account for the maximum possible unsecured exposure amount of the netting set that would not trigger a variation margin call. For example, a derivative contract with a high variation margin threshold would have a higher replacement cost compared to an equivalent derivative contract with a lower variation margin threshold. Section _.2 of the proposed rule would define the variation margin threshold and the minimum transfer amount. The variation margin threshold would mean the amount of the credit exposure of a banking organization to its counterparty that, if exceeded, would require the counterparty to post variation margin to the banking organization. The minimum transfer amount would mean the smallest amount of variation margin that may be transferred between counterparties to a netting set. In the agencies' experience, variation margin agreements can include variation margin thresholds that are set at such high levels that the netting set is effectively unmargined since the counterparty would never breach the threshold and be required to post variation margin. The agencies are concerned that in such a case the variation margin threshold would result in an unreasonably high replacement cost, because it is not attributable to the risk associated with the derivative contract but rather the terms of the variation margin agreement. Therefore, the proposal would cap the exposure amount of a netting set subject to a variation margin agreement at the exposure amount of the same netting set calculated as if the netting set were not subject to a variation margin agreement. 28 28 There could be a situation unrelated to the value of the variation margin threshold in which the exposure amount of a margined netting set would be greater than the exposure amount of an equivalent unmargined netting set. For example, in the case of a margined netting set composed of short-term transactions with a residual maturity of 10 business days or less, the risk horizon would be the MPOR, which the proposal would floor at 10 business days. The risk horizon for an equivalent unmargined netting set also would be equal to 10 business days because this would be the floor for the remaining maturity of such a netting set. However, the maturity factor for the margined netting set would be greater than the one for the equivalent unmargined netting set because of the application of a factor of 1.5 to margined derivative contracts. In such an instance, the exposure amount of a margined netting set would be more than the exposure amount of an equivalent unmargined netting set by a factor of 1.5, thus triggering the cap. In addition, in the case of disputes, the MPOR of a margined netting set would be doubled, which could further increase the exposure amount of a margined netting set composed of short-term transactions with a residual maturity of 10 business days or less above an equivalent unmargined netting set. The agencies believe, however, that such instances rarely occur and thus would have minimal effect on banking organizations' regulatory capital. For a netting set that is subject to multiple variation margin agreements, or a hybrid netting set, a banking organization would determine replacement cost using the methodology described in § _.132(c)(11)(i) of the proposed rule. A hybrid netting set is a netting set composed of at least one derivative contract subject to variation margin agreement under which the counterparty must post variation margin and at least one derivative contract that is not subject to such a variation margin agreement. In particular, a banking organization would use the methodology described in § _.132(c)(6)(ii) for netting sets subject to a variation margin agreement, except that the variation margin threshold would equal the sum of the variation margin thresholds of all the variation margin agreements within the netting set and the minimum transfer amount would equal the sum of the minimum transfer amounts of all the variation margin agreements within the netting set. For multiple netting sets subject to a single variation margin agreement, a banking organization would assign a single replacement cost to the multiple netting sets, according to the following formula, as provided under § _.132(c)(10)(i) of the proposed rule: Replacement Cost = max {Σ NS max { V NS ; 0}− max { C MA ; 0}; 0} + max {Σ NS min { V NS ; 0}− min { C MA ; 0}; 0}, Where: NS is each netting set subject to the variation margin agreement MA; V NS is the sum of the fair values (after excluding any valuation adjustments) of the derivative contracts within the netting set NS; and C MA is the sum of the net independent collateral amount and the variation margin amount applicable to the derivative contracts within the netting sets subject to the single variation margin agreement. The component max { S NS max { V NS ; 0}− max { C MA ; 0}; 0} reflects the exposure amount produced by the netting sets that have current positive market value. The exposure amount can be offset by variation margin and independent collateral when the banking organization is the net receiver of such amounts ( i.e., when C MA is positive). However, netting sets that have current negative market value would not be allowed to offset the exposure amount. The component max { S NS min { V NS ; 0}− min { C MA ; 0}; 0} reflects the exposure amount produced when the banking organization posts variation margin and independent collateral to its counterparty ( i.e., this component contributes to replacement cost only in instances when C MA is negative), and the exposure amount would be offset by the netting sets that have current negative market value. Question 4: What are the potential consequences of the proposal to cap the exposure amount for a netting set subject to a variation margin agreement at the exposure amount for such netting set in the absence of a variation margin agreement? Question 5: What are the potential consequences of the proposal to exclude from the fair value amount of the derivative contract any valuation adjustments? What are the potential consequences of instead using the market value of the derivative contract less any valuation adjustments that are specific to the banking organization? Question 6: The agencies invite comment on the proposed alignment of the standard supervisory haircuts with the maturity factor adjustments. How could the agencies better align the standard supervisory haircuts under the capital rule with the maturity factor adjustments provided under SA-CCR? Question 7: The agencies invite comment on the proposed definitions included in this proposal. What, if any, alternative definitions should the agencies consider, particularly to achieve greater consistency across other agencies' regulations? 3. Aggregated Amount and Hedging Set Amounts Under § _.132(c)(7) of the proposed rule, the PFE of a netting set would be the product of the PFE multiplier and the aggregated amount. The proposal would define the aggregated amount as the sum of all hedging set amounts within the netting set. This can be represented as follows: PFE = PFE multiplier * aggregated amount, Where: aggregated amount is the sum of each hedging set amount within the netting set. To determine the hedging set amounts, a banking organization would first group into separate hedging sets derivative contracts that share similar risk factors based on the following asset classes: Interest rate, exchange rate, credit, equity, and commodities. Basis derivative contracts and volatility derivative contracts would require separate hedging sets. A banking organization would then determine each hedging set amount using asset-class specific formulas that allow for full or partial netting. If the risk of a derivative contract materially depends on more than one risk factor, whether interest rate, exchange rate, credit, equity, or commodity risk factor, a banking organization's primary federal regulator 29 may require the banking organization to include the derivative contract in each appropriate hedging set. The hedging set amount of a hedging set composed of a single derivative contract would equal the absolute value of the adjusted derivative contract amount of the derivative contract. 29 For the capital rule, the Board is the primary federal regulator for all bank and savings and loan holding companies, intermediate holding companies of foreign banks, and state member banks; the OCC is the primary federal regulator for all national banks and federal thrifts; and the FDIC is the primary federal regulatory for all state nonmember banks. Section _.132(c)(2)(iii) of the proposal provides the respective hedging set definitions. Specifically, an interest rate hedging set would mean all interest rate derivative contracts within a netting set that reference the same reference currency. Thus, there would be as many interest rate hedging sets in a netting set as distinct currencies referenced by the interest rate derivative contracts. A credit derivative hedging set would mean all credit derivative contracts within a netting set. Similarly, an equity derivative hedging set would mean all equity derivative contracts within a netting set. Thus, there could be at most one equity hedging set and one credit hedging set within a netting set. A commodity derivative contract hedging set would mean all commodity derivative contracts within a netting set that reference one of the following commodity classes: Energy, metal, agricultural, or other commodities. Thus, there could be no more than four commodity derivative contract hedging sets within a netting set. The proposal would define an exchange rate hedging set as all exchange rate derivative contracts within a netting set that reference the same currency pair. Thus, under this approach, there could be as many exchange rate hedging sets within a netting set as distinct currency pairs referenced by the exchange rate derivative contracts. This treatment would be generally consistent with the Basel Committee's standard. The agencies recognize, however, that the proposed approach to grouping exchange rate derivative contracts into hedging sets would not recognize economic relationships of exchange rate chains ( i.e., when more than one currency pair can offset the risk of another). For example, a Yen/Dollar forward contract and a Dollar/Euro forward contract, taken together, may be economically equivalent, with properly set notional amounts, to a Yen/Euro forward contract. To capture this economic relationship, the agencies are seeking comment on an alternative definition of an exchange rate hedging set that differs from the one in the Basel Committee's standard. Under the alternative definition, an exchange rate derivative contract hedging set would mean all exchange rate derivative contracts within a netting set that reference the same non-U.S. currency. Thus, a banking organization would be required, under the proposed alternative definition, to include in separate hedging sets an exchange rate derivative contract that references two or more foreign currencies. For example, a banking organization would include the Yen/Euro forward contract both in one hedging set consisting of Yen derivative contracts and another hedging set consisting of Euro derivative contracts. Under this alternative approach, there could be as many exchange rate derivative contract hedging sets as non-U.S. referenced currencies. The proposal sets forth treatments for volatility derivative contracts and basis derivative contracts separate from the treatment for the risk factors described above. A basis derivative contract would mean a non-foreign-exchange derivative contract ( i.e., the contract is denominated in a single currency) in which the cash flows of the derivative contract depend on the difference between two risk factors that are attributable solely to one of the following derivative asset classes: Interest rate, credit, equity, or commodity. A basis derivative contract hedging set would mean all basis derivative contracts within a netting set that reference the same pair of risk factors and are denominated in the same currency. A volatility contract would mean a derivative contract in which the payoff of the derivative contract explicitly depends on a measure of the volatility of an underlying risk factor to the derivative contract. Examples of volatility derivative contracts include variance and volatility swaps and options on realized or implied volatility. A volatility derivative contract hedging set would mean all volatility derivative contracts within a netting set that reference one of interest rate, exchange rate, credit, equity, or commodity risk factors, separated according to the requirements under § _.132(c)(2)(iii)(A)-(E) of the proposed rule. Question 8: Should SA-CCR include the alternative treatment for exchange rate derivative contracts in order to recognize the economic equivalence of chains of exchange rate transactions? What would be the benefit of including such an alternative treatment? Commenters providing information regarding an alternative treatment are encouraged to provide support for such treatment, together with information regarding any associated burden and complexity. a. Interest Rate Derivative Contracts The hedging set amount for interest rate derivative contracts would be determined under § _.132(c)(8)(i) of the proposed rule. The agencies recognize that interest rate derivative contracts with close tenors ( i.e., the amount of time remaining before the end date of the derivative contract) are generally highly correlated, and thus provide a greater offset relative to interest rate derivative contracts that do not have close tenors. Accordingly, the formula to determine the hedging set amount for interest rate derivative contracts would permit full offsetting within a tenor category, and partial offsetting across tenor categories. The tenor categories are less than one year, between one and five years, and more than five years. The proposal would use a correlation factor of 70 percent across adjacent tenor categories and a correlation factor of 30 percent across nonadjacent tenor categories. 30 The tenor of a derivative contract would be based on the period between the present date and the end date of the derivative contract, which, under the proposal, would mean the last date of the period referenced by the derivative contract, or if the derivative contract references another instrument, the period referenced by the underlying instrument. 30 See “Foundations of the standardised approach for measuring counterparty credit risk exposures.” Accordingly, a banking organization would calculate the hedging set amount for interest rate derivative contracts according to the following formula: EP17DE18.000 The proposal also includes a simpler formula that does not provide an offset across tenor categories. In this case, the hedging set amount of the interest rate derivative contracts would equal the sum of the absolute amounts of each tenor category, which would be the sum of the adjusted derivative contract amounts within each respective tenor category. The simpler formula would always result in a more conservative measure of the hedging set amount for interest rate derivative contracts of different tenor categories but may be less burdensome for banking organizations with smaller interest rate derivative contract portfolios. Under the proposal, a banking organization could elect to use this simpler formula for some or all of its interest rate derivative contracts. b. Exchange Rate Derivative Contracts The hedging set amount for exchange rate derivative contracts would be determined under § _.132(c)(8)(ii) of the proposed rule. The agencies recognize that exchange rate derivative contracts that reference the same currency pair generally are driven by the same market factor ( i.e., the exchange spot rate between these currencies) and thus are highly correlated. Therefore, the formula to determine the hedging set amount for exchange rate derivative contracts would allow for full offsetting within the exchange rate derivative contract hedging set. Accordingly, the hedging set amount for exchange rate derivative contracts would equal the absolute value of the sum of the adjusted derivative contract amounts within the hedging set. c. Credit Derivative Contracts and Equity Derivative Contracts A banking organization would use the same formula to determine the hedging set amount for both its credit derivative contracts and equity derivative contracts. The formula would be provided under § _.132(c)(8)(iii) of the proposed rule. The formula would allow for full offsetting for credit or equity contracts referencing the same entity, and would use a single-factor model to allow for partial offsetting when aggregating across distinct reference entities. The proposed single-factor model recognizes that credit spreads and equity prices of different entities within a hedging set are, on average, positively correlated. 31 The proposed single-factor model would use a single systematic component to describe joint movement of credit spreads or equity prices that are responsible for positive correlations, and would use an idiosyncratic component to describe entity-specific dynamics of each derivative contract. 31 The dependence between N random variables can be described by an NxN correlation matrix. In the most general case, such a correlation matrix requires estimation of N*(N-1)/2 individual correlation parameters. Estimating these correlations is problematic when N is large. Factor models are a popular means of reducing the number of independent correlation parameters by assuming that each random variable is driven by a combination of a small number of systematic factors (which are the same for all N random variables) and an idiosyncratic factor (which is unique to each random variable and is independent from all other factors). The simplest factor model is a single-factor model that assumes that a single systematic factor drives all N random variables. The proposal would provide supervisory correlation parameters for credit derivative contracts and equity derivative contracts that depend on whether the derivative contract references a single name entity or an index. A single name entity credit derivative and a single name entity equity derivative would receive a correlation factor of 50 percent, while a credit index and equity index would receive a correlation factor of 80 percent, the higher number reflecting partial diversification of idiosyncratic risk within an index. The pairwise correlation between two entities is the product of the corresponding correlation factors, so that the pairwise correlation between two single name entities is 25 percent, between one single name entity and one index is 40 percent, and between two indices is 64 percent. Thus, the pairwise correlation between two single name entities is less than the pairwise correlation between an entity and an index, which is less than the pairwise correlation between two indices. The application of a higher correlation factor does not necessarily result in a higher exposure amount, as there would be a reduction of the exposure amount for balanced portfolios but an increase in the exposure amount for directional portfolios. 32 32 A higher correlation factor means that the underlying risk factors are more closely aligned. For a directional portfolio, more alignment between the risk factors would result in a more concentrated risk, leading to a higher exposure amount. For a balanced portfolio, more alignment between the risk factors would result in more offsetting of risk, leading to a lower exposure amount. A banking organization would calculate the hedging set amount for a credit derivative contract hedging set or an equity derivative contract hedging set according to the following formula: EP17DE18.001 Where: k is each reference entity within the hedging set; K is the number of reference entities within the hedging set; AddOn ( Ref k ) equals the sum of the adjusted derivative contract amounts for all derivative contracts within the hedging set that reference reference entity k; and r k equals the applicable supervisory correlation factor, as provided in Table 2. d. Commodity Derivative Contracts A banking organization would use a similar single-factor model to determine the hedging set amount for commodity derivative contracts as it would use for credit derivative contracts and equity derivative contracts. The hedging set amount of commodity derivative contracts would be determined under § _.132(c)(8)(iv) of the proposed rule. Under the proposal, a banking organization would group commodity derivatives into one of four hedging sets based on the following commodity classes: Energy, metal, agricultural and other. Under the single-factor model used for commodity derivative contracts, a banking organization would be able to offset fully all derivative contracts within a hedging set that reference the same commodity type; however, the banking organization could only partially offset derivative contracts within a hedging set that reference different commodity types. For example, a hedging set composed of energy commodities may include crude oil derivatives and coal derivatives. Under the proposal, a banking organization could fully offset all crude oil derivatives; however, it could only partially offset a crude oil derivative against a coal derivative. In addition, a banking organization cannot offset commodity derivatives that belong to different hedging sets ( i.e., a forward contract on crude oil cannot hedge a forward contract on corn). The agencies recognize that specifying individual commodity types is operationally difficult. Indeed, it is likely impossible to specify sufficiently all relevant distinctions between commodity types so that all basis risk is captured. Accordingly, the proposal would allow banking organizations to recognize commodity types without regard to characteristics such as location or quality. For example, a banking organization may recognize crude oil as a commodity type, and would not need to distinguish further between West Texas Intermediate and Saudi Light crude oil. The agencies expect to monitor the commodity-type distinctions made within the industry to ensure that they are sufficiently correlated for full-offset treatment under SA-CCR. The agencies are proposing not to provide separate supervisory factors for electricity and oil/gas components of the energy commodity class, as provided under the Basel Committee standard. Rather, the agencies are proposing to provide a single supervisory factor for an energy commodity class that generally would include derivative contracts that reference electricity and oil/gas. In addition, the agencies are proposing not to provide more granular commodity categories than those provided under the Basel Committee's standard. The agencies believe that more granular commodity classes could pose operational challenges for banking organizations and could negate certain hedging benefits that may otherwise be available. This is because SA-CCR only permits offsetting within commodity classes, and additional commodity classes thereby may reduce the derivative contracts across which a banking organization may hedge. A banking organization would calculate the hedging set amount for a commodity derivative contract hedging set according to the following formula: EP17DE18.002 Where: k is each commodity type within the hedging set; K is the number of commodity types within the hedging set; AddOn ( Type k ) equals the sum of the adjusted derivative contract amounts for all derivative contracts within the hedging set that reference commodity type k ; and r equals the applicable supervisory correlation factor, as provided in Table 2. Question 9: What other commodity classes should the agencies consider for hedging set treatment, taking into account operational challenges for banking organizations and potential hedging benefits of the derivative contracts? What would be the consequences of not specifying the commodity types within each commodity class that are eligible for full offsetting? What level of granularity regarding the attributes of a commodity type would be required to appropriately distinguish among them? 4. PFE Multiplier Under SA-CCR, the aggregated amount formula would not recognize financial collateral and would assume a zero market value for all derivative contracts. However, excess collateral and negative fair value of the derivative contracts within the netting set reduce PFE. This reduction in PFE is achieved through the PFE multiplier, which would recognize, if present, the amount of excess collateral available and the negative fair value of the derivative contracts within the netting set. Under the proposal, the PFE multiplier would decrease exponentially from a value of one as the value of the financial collateral held exceeds the net fair value of the derivative contracts within the netting set, subject to a floor of 0.05. The PFE multiplier would decrease as the net fair value of the derivative contracts within the netting set decreases below zero, to reflect that “out-of-the-money” transactions have less chance to return to a positive, “in-the-money” value. Specifically, when the component V−C is greater than zero, the multiplier would be equal to one. When the component V−C is less than zero, the multiplier would be less than one and would decrease exponentially in value as the absolute value of V−C increases. The PFE multiplier would approach the floor of 0.05 as the absolute value of V−C becomes very large as compared with the aggregated amount of the netting set. Thus, the combination of the exponential function and the floor provides a sufficient level of conservatism by prohibiting overly favorable decreases in PFE when excess collateral increases and preventing PFE from reaching zero at any amounts of margin. Under § _.132(c)(7)(i) of the proposal, a banking organization would calculate the PFE multiplier according to the following formula: EP17DE18.003 Where: V is the sum of the fair values (after excluding any valuation adjustments) of the derivative contracts within the netting set; C is the sum of the net independent collateral amount and the variation margin amount applicable to the derivative contracts within the netting set; and A is the aggregated amount of the netting set. Question 10: Can the PFE multiplier be calibrated to more appropriately recognize the risk-reducing effects of collateral and a netting set with a negative market value for purposes of the PFE calculation? Is the 5 percent floor appropriate, particularly in view of the exponential functioning of the formula for PFE multiplier, why or why not? Commenters are encouraged to provide data to support their responses. 5. PFE Calculation for Nonstandard Margin Agreements When a single variation margin agreement covers multiple netting sets, the parties exchange variation margin based on the aggregated market value of the netting sets. Thus, netting sets with positive and negative market values can offset one another to reduce the amount of variation margin that the parties must exchange. However, a banking organization's exposure amount for a netting set is floored by zero. Thus, for purposes of determining a banking organization's aggregate exposure amount, a netting set with a negative market value cannot offset a netting set with a positive market value. Therefore, in cases when a single variation agreement covers multiple setting sets and at least one netting set has a negative market value, the amount of variation margin exchanged between the parties will be insufficient relative to the banking organization's exposure amount for the netting sets. 33 Under § _.132(c)(10)(ii) of the proposed rule, for multiple netting sets covered by a single variation margin agreement such that the banking organization's counterparty must post variation margin, a banking organization would be required to assign a single PFE equal to the sum of PFEs for each such netting set calculated as if none of the derivative contracts within the netting set are subject to a variation margin agreement. 33 For example, consider a variation margin agreement with a zero threshold amount that covers two netting sets, one with a market value of 100 and the other with a market value of negative 100. The aggregate market value of the netting sets would be zero and thus no variation margin would be exchanged. However, the banking organization's aggregate exposure amount for these netting sets would be equal to 100 because the negative market value of the second netting set would not be available to offset the positive market value of the first netting set. In the event of default of the counterparty, the banking organization would pay the counterparty 100 for the second netting set and would be exposed to a loss of 100 on the first netting set. Since swap margin requirements came into effect in September 2016, the amounts of netting agreements that are subject to more than one variation margin agreement and hybrid netting sets have increased. While all derivative contracts within a netting set can fully offset each other in the replacement cost component calculation, regardless of whether the netting set is subject to multiple variation margin agreements or is a hybrid netting set, margined derivative contracts cannot offset unmargined derivative contracts in the PFE component calculation because of different applicable risk horizons. Similarly, derivative contracts with different MPORs cannot offset each other. Therefore, the agencies are proposing, under § _.132(c)(11)(ii) of the proposed rule, that for a netting set subject to multiple variation margin agreements such that the counterparty to each variation margin agreement must post variation margin, or a netting set composed of at least one derivative contract subject to a variation margin agreement under which the counterparty to the derivative contract must post variation margin and at least one derivative contract that is not subject to such a variation margin agreement, a banking organization must divide the netting set into sub-netting sets and calculate the aggregated amount for each sub-netting set. All derivative contracts within the netting set that are not subject to a variation margin agreement or that are subject to a variation margin agreement under which the counterparty is not required to post variation margin would form a single sub-netting set. A banking organization would calculate the aggregated amount for this sub-netting set as if the netting set were not subject to a variation margin agreement. All derivative contracts within the netting set that are subject to variation margin agreements under which the counterparty must post variation margin and that share the same MPOR value would form another sub-netting set. A banking organization would calculate the aggregated amount for this sub-netting set as if the netting set is subject to a variation margin agreement, using the MPOR value shared by the derivative contracts within the netting set. A banking organization would calculate the PFE multiplier at the netting set level. 6. Adjusted Derivative Contract Amount The agencies intend for the adjusted derivative contract amount to represent a conservative estimate of EEPE of a netting set consisting of a single derivative contract, assuming zero market value and zero collateral, that is either positive (if a long position) or negative (if a short position). 34 The proposal would calculate the adjusted derivative contract amount as a product of four quantities: The adjusted notional amount, the applicable supervisory factor, the applicable supervisory delta adjustment, and the maturity factor. This can be represented as follows: 34 For a derivative contract that can be represented as a combination of standard option payoffs (such as collar, butterfly spread, calendar spread, straddle, and strangle), each standard option component would be treated as a separate derivative contract. For a derivative contract that includes multiple-payment options, (such as interest rate caps and floors) each payment option could be represented as a combination of effective single-payment options (such as interest rate caplets and floorlets). Linear derivative contracts (such as swaps) would not be decomposed into components. adjusted derivative contract amount = d i * δ i * MF i * SF i Where: d i is the adjusted notional amount; δ i is the applicable supervisory delta adjustment; MF i is the applicable maturity factor; and SF i is the applicable supervisory factor. The adjusted notional amount accounts for the size of the derivative contract and reflects attributes of the most common derivative contracts in each asset class. The supervisory factor would convert the adjusted notional amount of the derivative contract into an EEPE based on the measured volatility specific to each asset class over a one-year horizon. 35 Multiplication by the supervisory delta adjustment accounts for the sensitivity of a derivative contract (scaled to unit size) to the underlying primary risk factor, including the correct sign (positive or negative) to account for the direction of the derivative contract amount relative to the primary risk factor. 36 Finally, multiplication by the maturity factor scales down, if necessary, the derivative contract amount from the standard one-year horizon used for supervisory factor calibration to the risk horizon relevant for a given contract. The adjusted derivative contract amount is determined under § _.132(c)(9) of the proposed rule. 35 Specifically, the supervisory factors are intended to reflect the EEPE of a single at-the-money linear trade of unit size, zero market value and one-year maturity referencing a given risk factor in the absence of collateral. 36 Sensitivity of a derivative contract to a risk factor is the ratio of the change in the market value of the derivative contract caused by a small change in the risk factor to the value of the change in the risk factor. In a linear derivative contract, the payoff of the derivative contract moves at a constant rate with the change in the value of the underlying risk factor. In a nonlinear contract, the payoff of the derivative contract does not move at a constant rate with the change in the value of the underlying risk factor. The sensitivity is positive if the derivative contract is long the risk factor and negative if the derivative contract is short the risk factor. a. Adjusted Notional Amount A banking organization would apply the same formula to interest rate derivative contracts and credit derivative contracts to arrive at the adjusted notional amount. For such contracts, the adjusted notional amount would equal the product of the notional amount of the derivative contract, as measured in U.S. dollars, using the exchange rate on the date of the calculation, and the supervisory duration. The agencies intend for the supervisory duration to recognize that interest rate derivative contracts and credit derivative contracts with a longer tenor would have a greater degree of variability than an identical derivative contract with a shorter tenor for the same change in the underlying risk factor (interest rate or credit spread). The supervisory duration would be calculated for the period that starts at S and ends at E. S would be equal to the number of business days between the present date and the start date for the derivative contract, or zero if the start date has passed, and E would be equal to the number of business days from the present date until the end date for the derivative contract. The supervisory duration is based on the assumption of a continuous stream of equal payments and a constant continuously compounded interest rate of 5 percent. The exponential function provides discounting for S and E at 5 percent continuously compounded. In all cases, the supervisory duration is floored at 10 business days (or 0.04, based on an average of 250 business days per year). The supervisory duration formula is provided as follows: EP17DE18.004 Where: S is the number of business days from the present day until the start date for the derivative contract, or zero if the start date has already passed; and E is the number of business days from the present day until the end date for the derivative contract. For an interest rate derivative contract or credit derivative contract that is a variable notional swap, the notional amount would equal the time-weighted average of the contract notional amounts of such a swap over the remaining life of the swap. For an interest rate derivative contract or credit derivative contract that is a leveraged swap, in which the notional amounts of all legs of the derivative contract are divided by a factor and all rates of the derivative contract are multiplied by the same factor, the notional amount would equal the notional amount of an equivalent unleveraged swap. For an exchange rate derivative contract, the adjusted notional amount would equal the notional amount of the non-U.S. denominated currency leg of the derivative contract, as measured in U.S. dollars using the exchange rate on the date of the calculation. In general, the non-U.S. dollar denominated currency leg is the source of exchange rate volatility. If both legs of the exchange rate derivative contract are denominated in currencies other than U.S. dollars, the adjusted notional amount of the derivative contract would be the largest leg of the derivative contract, measured in U.S. dollars. Under the agencies' alternative approach for treating exchange rate derivative contracts discussed above, the adjusted notional amount of an exchange rate derivative contract would be the notional amount of the derivative contract that is denominated in the foreign currency of the hedging set, as measured in U.S. dollars using the exchange rate on the date of the calculation. For an exchange rate derivative contract with multiple exchanges of principal, the notional amount would equal the notional amount of the derivative contract multiplied by the number of exchanges of principal under the derivative contract. For an equity derivative contract or a commodity derivative contract, the adjusted notional amount is the product of the fair value of one unit of the reference instrument underlying the derivative contract and the number of such units referenced by the derivative contract. The proposed treatment is designed to reflect the current price of the underlying reference entity. For example, if a banking organization has a derivative contract that references 15,000 pounds of frozen concentrated orange juice currently priced at $0.0005 a pound then the adjusted notional amount would be $75. The payoff of a volatility derivative contract generally is determined based on a notional amount and the realized or implied volatility (or variance) referenced by the derivative contract and not necessarily the unit price of the underlying reference entity. Accordingly, for an equity derivative contract or a commodity derivative contract that is a volatility derivative contract, a banking organization would be required to replace the unit price with the underlying volatility referenced by the volatility derivative contract and replace the number of units with the notional amount of the volatility derivative contract. The agencies anticipate that for most derivative contracts banking organizations would be able to determine the adjusted notional amount using one of the formulas or methodologies described above. The agencies recognize, however, that such approaches may not be applicable to all types of derivative contracts, and that a different approach may be necessary to determine the adjusted notional amount of a derivative contract. In such a case, the agencies would expect a banking organization to consult with its appropriate federal supervisor prior to using an alternative approach to the formulas or methodologies described above. Question 11: The agencies invite comment on the proposed approaches to determine the adjusted notional amount of derivative contracts. In particular, how can the agencies improve the approaches set forth in the proposal to determine the adjusted notional amount for nonstandard derivative contracts so that they are appropriate for such transactions, including using formulas of the market value of underlying contracts? What, if any, nonstandard derivative contracts are not addressed by the proposal, and what approaches should be used to determine the adjusted notional amount for those contracts? Please provide examples and descriptions of how such adjusted notional amounts would be determined. b. Supervisory Factor Table 2 to § _.132 of the proposed rule provides the proposed supervisory factors. The agencies are proposing to use the same supervisory factors provided in the Basel Committee standard, with the exception of the supervisory factors for credit derivative contracts that reference single-name entities, which are based on the applicable credit rating of the reference entity. 37 Section 939A of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) prohibits the use of credit ratings in federal regulations, and therefore, the agencies are unable to propose implementing this feature of the Basel Committee standard. 38 Accordingly, the agencies are proposing an approach that satisfies the requirements of section 939A while allowing for a level of granularity among the supervisory factors applicable to single-name credit derivatives that is generally consistent with the Basel Committee standard. 37 Specifically, the BCBS supervisory factors are as follow (in percent): AAA and AA—0.38, A—0.42; BBB—0.54; BB—1.06; B—1.6; CCC—6.0. 38 Public Law 11-203, 124 Stat. 1376 (2010), § 939A. This provision is codified as part of the Securities Exchange Act of 1934 at 15 U.S.C. 78o-7. Specifically, the agencies are proposing to apply a supervisory factor to single-name credit derivative contracts based on the following categories: Investment grade, speculative grade, and sub-speculative grade. For credit derivative contracts that reference indices, the agencies are proposing to apply a higher supervisory factor to speculative grade indices than investment grade indices, because of the additional risk present with speculative grade credits. The proposal would maintain the current definition of investment grade in the capital rule and would propose new definitions for speculative grade and sub-speculative grade. The investment grade category would capture single-name credit derivative contracts consistent with the three highest supervisory factor categories under the Basel Committee standard. The capital rule defines investment grade to mean that the entity to which the banking organization is exposed through a loan or security, or the reference entity with respect to a credit derivative contract, has adequate capacity to meet financial commitments for the projected life of the asset or exposure. Such an entity or reference entity has adequate capacity to meet financial commitments, as the risk of its default is low and the full and timely repayment of principal is expected. 39 39 See 12 CFR 3.2 (OCC); 12 CFR 217.2 (Board); and 12 CFR 324.2 (FDIC). The agencies intend for the speculative grade category to cover single-name credit derivative contracts consistent with the next two lower supervisory factor categories under the Basel Committee standard. The proposal would define speculative grade to mean that the reference entity has adequate capacity to meet financial commitments in the near term, but is vulnerable to adverse economic conditions, such that should economic conditions deteriorate, the reference entity would present an elevated default risk. The agencies intend for the sub-speculative grade category to cover the lowest supervisory factor category under the Basel Committee standard. The proposal would define sub-speculative grade to mean that the reference entity depends on favorable economic conditions to meet its financial commitments, such that should economic conditions deteriorate, the reference entity likely would default on its financial commitments. The agencies believe that each of the proposed categories include exposures that perform largely in accordance with the performance criteria that would define each category under the proposed rule, and therefore would result in capital requirements that are largely equivalent to those resulting from application of the supervisory factors under the Basel Committee standard. To determine the supervisory factor that would apply to the investment and speculative grade categories, the agencies reviewed ratings issuance data from 2012 to 2017, using information made publicly available by the Depository Trust & Clearing Corporation (DTCC). 40 The agencies used the DTCC data to determine the weighted-average supervisory factor for the investment and speculative grade categories, and rounded that supervisory factor to the nearest tenth. The agencies are proposing to retain the supervisory factor from the Basel Committee standard for the sub-speculative grade category, because that category would consist only of single name credit derivatives with the lowest credit quality. 40 Markit North America, Inc., accessed via Wharton Research Data Services (WRDS), wrds-web.wharton.upenn.edu/wrds/about/databaselist.cfm. The agencies considered using the same investment grade/non-investment grade distinction as provided under the standardized approach for determining whether a guarantor is an eligible guarantor for purposes of the rule. However, the agencies are concerned that this approach would not provide for sufficient risk differentiation across credit derivative products. The agencies also considered calibrating the supervisory factor for the investment and speculative grade categories by using a simple average of the ratings issued in accordance with the DTCC data, or the most conservative supervisory factor applicable to the credit ratings that mapped to each category. For example, if for purposes of the investment grade category the DTCC data demonstrated that the average rating in that category is AA (using a simple average of all ratings issued for single-name credit derivatives), the proposal would apply a 0.38 percent supervisory factor to investment grade single-name credit derivatives, because that supervisory factor corresponds to a AA rating under the Basel Committee standard. Under the other alternative considered, the proposal would apply the most conservative ( i.e., stringent) supervisory factor among the supervisory factors that apply to a given category. Under this approach, a supervisory factor of 1.6 percent would apply to speculative grade single-name credit derivatives, as that is the most stringent supervisory factor under the Basel Committee standard that corresponds to the categories intended to be captured by the term “speculative grade.” The agencies believe, however, that the weighted-average approach more accurately reflects the ratings issuance data and therefore would more closely align to the single-name credit derivatives held in banking organizations' derivatives portfolios. The agencies expect that banking organizations would conduct their own due diligence to determine the appropriate category for a single-name credit derivative, in view of the performance criteria in the definitions for each category under the proposed rule. Although a banking organization would be able to consider the credit rating for a single-name credit derivative in making that determination, the credit rating should be part of a multi-factor analysis. In addition, the agencies would expect a banking organization to support its analysis and assignment of the respective credit categories. Interest rate derivative contracts and exchange rate derivative contracts would each be subject to a single supervisory factor. Equity derivative contracts that reference single-name equities would be subject to a higher supervisory factor than derivative contracts that reference equity indices in recognition of the effect of diversification in the index. Commodity derivative contracts that reference energy would receive a higher supervisory factor than commodity derivative contracts that reference metals, agriculture, and other commodities (each of which would receive the same supervisory factor), to reflect the observed additional volatility inherent in the energy markets. For volatility derivative contracts, a banking organization would multiply the applicable supervisory factor based on the asset class related to the volatility measure by a factor of five. The agencies are proposing this treatment because volatility derivative contracts are inherently subject to more price volatility than the underlying asset classes they reference. For basis derivative contracts, the agencies are proposing to multiply the applicable supervisory factor based on the asset class related to the basis measure by a factor of one half. The agencies are proposing this treatment because the volatility of a basis between highly correlated risk factors would be less than the volatility of the risk factors (assuming the factors have equal volatility). Table 2—Supervisory Option Volatility and Supervisory Factors for Derivative Contracts Asset class Subclass Supervisory option volatility (%) Supervisory correlation parameters (%) Supervisory factor a (%) Interest rate N/A 50 N/A 0.5 Exchange rate N/A 15 N/A 4.0 Credit, single name Investment grade 100 50 0.5 Speculative grade 100 50 1.3 Sub-speculative grade 100 50 6.0 Credit, index Investment Grade 80 80 0.38 Speculative Grade 80 80 1.06 Equity, single name N/A 120 50 32 Equity, index N/A 75 80 20 Commodity Energy 150 40 40 Metals 70 40 18 Agricultural 70 40 18 Other 70 40 18 a The applicable supervisory factor for basis derivative contract hedging sets is equal to one-half of the supervisory factor provided in Table 2, and the applicable supervisory factor for volatility derivative contract hedging sets is equal to 5 times the supervisory factor provided in Table 2. Question 12: Can the agencies improve the supervisory factors under the proposal to reflect more appropriately the volatility specific to each asset class? What, if any, additional categories and respective supervisory factors should the agencies consider? Commenters supporting changes to the supervisory factors or the categories within the asset classes should provide analysis supporting their request. Question 13: Can the agencies improve the non-ratings-based methodology under the proposal to determine the supervisory factor applicable to a single-name credit derivative contract? Are there other non-ratings-based methodologies that could be used to determine the applicable supervisory factor for single-name credit derivatives? What would be the benefit of any such alternative relative to the proposal? What would be the burden associated with the proposed methodology, as well as any alternative suggested by commenters? c. Supervisory Delta Adjustment Under the proposal, derivative contracts that are not options or collateralized debt obligation tranches are considered to be linear in the primary underlying risk factor. For such derivative contracts, the supervisory delta adjustment would need to account only for the direction of the derivative contract (positive or negative) with respect to the underlying risk factor. Therefore, the supervisory delta adjustment would be equal to one if such a derivative contract is long in the primary risk factor and negative one if such a derivative contract is short in the primary risk factor. A derivative contract is long in the primary risk factor if the fair value of the instrument increases when the value of the primary risk factor increases. A derivative contract is short in the primary risk factor if the fair value of the instrument decreases when the value of the primary risk factor increases. Because option contracts are nonlinear, the proposal would require a banking organization to use the Black-Scholes Model to determine the supervisory delta adjustment, as provided in Table 2. The agencies are proposing to use the Black-Scholes Model to determine the supervisory delta adjustment because the model is a widely used option-pricing model within the industry. The Black Scholes-Model assumes, however, that the underlying risk factor is greater than zero. In particular, the Black Scholes delta formula contains a ratio P/K that is an input into the natural logarithm function. P is the fair value of the underlying instrument and K is the strike price. Because the natural logarithm function can be defined only for amounts greater than zero, a reference risk factor with a negative value ( e.g., negative interest rates) would make the supervisory delta adjustment inoperable. Therefore, the formula incorporates a parameter, lambda, the purpose of which is to adjust the fraction P/K so that it has a positive value. EP17DE18.005 Where: F is the standard normal cumulative distribution function; 41 A banking organization would be required to represent binary options with strike K as the combination of one bought European option and one sold European option of the same type as the original option (put or call) with the strike prices set equal to 0.95 * K and 1.05 * K. The size of the position in the European options must be such that the payoff of the binary option is reproduced exactly outside the region between the two strikes. The absolute value of the sum of the adjusted derivative contract amounts of the bought and sold options is capped at the payoff amount of the binary option. P equals the current fair value of the instrument or risk factor, as applicable, underlying the option; K equals the strike price of the option; T equals the number of business days until the latest contractual exercise date of the option; and l equals zero for all derivative contracts, except that for interest rate options that reference currencies currently associated with negative interest rates l must be equal to; max {−L + 0.1%; 0}; 42 42 The same value l i of must be used for all interest rate options that are denominated in the same currency. The value of l i for a given currency would be equal to the lowest value L of P i and K i of all interest rate options in a given currency that the banking organization has with all counterparties. and σ equals the supervisory option volatility, determined in accordance with Table 2. For a derivative contract that is a collateralized debt obligation tranche, the supervisory delta adjustment would be determined according to the following formula: EP17DE18.006 Where: A is the attachment point, which equals the ratio of the notional amounts of all underlying exposures that are subordinated to the banking organization's exposure to the total notional amount of all underlying exposures, expressed as a decimal value between zero and one; 43 43 In the case of a first-to-default credit derivative, there are no underlying exposures that are subordinated to the banking organization's exposure and A=0. In the case of a second-or-subsequent-to-default credit derivative, the smallest (n-1) notional amounts of the underlying exposures are subordinated to the banking organization's exposure. D is the detachment point, which equals one minus the ratio of the notional amounts of all underlying exposures that are senior to the banking organization's exposure to the total notional amount of all underlying exposures, expressed as a decimal value between zero and one; and The proposal would apply a positive sign to the resulting amount if the banking organization purchased the collateralized debt obligation tranche and would apply a negative sign if the banking organization sold the collateralized debt obligation tranche. d. Maturity Factor For derivative contracts not subject to a variation margin agreement, or derivative contracts subject to a variation margin agreement under which the counterparty to the variation margin agreement is not required to post variation margin to the banking organization, the risk horizon would be the lesser of one year and the remaining maturity of the derivative contract, subject to a 10-business-day floor. Accordingly, for such a derivative contract, a banking organization would use the following formula: EP17DE18.007 Where M equals the greater of 10 business days and the remaining maturity of the contract, as measured in business days. For derivative contracts subject to a variation margin agreement under which the counterparty must post variation margin, the risk horizon would be equal to the MPOR of the variation margin agreement. Accordingly, for such a derivative contract a banking organization would use the following formula: EP17DE18.008 Where MPOR refers to the period from the most recent exchange of collateral under a variation margin agreement with a defaulting counterparty until the derivative contracts are closed out and the resulting market risk is re-hedged. For derivative contracts that are not cleared transactions, MPOR would be floored at 10 business days. For derivative contracts between a clearing member banking organization and its client that are cleared transactions, MPOR would be floored at five business days. Under the capital rule, however, the exposure of a clearing member banking organization to its clearing member client is not a cleared transaction where the clearing member banking organization is either acting as a financial intermediary and enters into an offsetting transaction with a CCP or where the clearing member banking organization provides a guarantee to the CCP on the performance of the client. Accordingly, in such cases, MPOR may not be less than 10 business days. If either a cleared or noncleared derivative contract is subject to an outstanding dispute over variation margin, the applicable MPOR would be twice the MPOR provided for those transactions in the absence of such a dispute. 44 For a derivative contract that is within a netting set that is composed of more than 5,000 derivative contracts that are not cleared transactions, MPOR would be floored at 20 business days. 44 In general, a party will not have violated its obligation to collect or post variation margin from or to a counterparty if the counterparty has refused or otherwise failed to provide or accept the required variation margin to or from the party; and the party has made the necessary efforts to collect or post the required variation margin, including the timely initiation and continued pursuit of formal dispute resolution mechanisms; or has otherwise demonstrated that it has made appropriate efforts to collect or post the required variation margin; or commenced termination of the derivative contract with the counterparty promptly following the applicable cure period and notification requirements. For a derivative contract in which on specified dates any outstanding exposure of the derivative contract is settled and the terms of the derivative contract are reset so that the fair value of the derivative contract is zero, the remaining maturity of the derivative contract is the period until the next reset date. 45 In addition, derivative contracts with daily settlement would be treated as unmargined derivative contracts. 45 See “Regulatory Capital Treatment of Certain Centrally-cleared Derivative Contracts Under Regulatory Capital Rules” (August 14, 2017), OCC Bulletin: 2017-27; FDIC Letter FIL-33-2017; and Board SR letter 07-17. 7. Example Calculation 46 To calculate the exposure amount of a netting set a banking organization would need to determine (1) the replacement cost, (2) the adjusted derivative contract amount of each derivative contract within the netting set, (3) the aggregated amount, which is the sum of each hedging set within the netting set, (4) the PFE multiplier, and (5) PFE. A banking organization may calculate these items together for derivative contracts that are subject to the same QMNA. 46 This example is intended only for use as an illustrative guide. The calculation mechanics may vary based on a variety of factors, including for example, the number of hedging sets, the frequency at which variation margin is exchanged, and certain terms of the derivative contracts and underlying reference assets. SA-CCR considers a number of risk attributes to determine the exposure amount of a derivative contract, or netting set thereof, and not all of those attributes are captured in this example. In this example, the netting set consists of two fixed versus floating interest rate swaps that are subject to the same QMNA. Table 4 summarizes the relevant contractual terms for these derivative contracts. The netting set is subject to a variation margin agreement, and the banking organization has received from the counterparty, as of the calculation date, variation margin in the amount of $10,000 and initial margin in [Text truncated at 120,000 characters. The full text is on the page linked above.] --- Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/fr%3A2018-24924. Public record. Not legal advice.