• PRU A4.6 PRU A4.6 Credit RWA — Unsettled Transactions, free deliveries and OTC Derivatives

    • Guidance

      1. Where settlement does not occur on the due date and neither party has released the relevant cash or Securities, an Authorised Person faces Market Risk, namely the differential between the contract price of the Securities and their current value in the market. In this case an Authorised Person also faces a Credit Risk Exposure for the Unsettled Transaction, for which the Authorised Person is required to hold regulatory capital. The relevant Credit Risk Exposure should be included in the calculation of Credit RWA for the Authorised Person.
      2. An Authorised Person is at risk for the whole amount of the contract (as well as any further movement in price) if it has delivered its leg of a contract before receipt of the other leg. In this case an Authorised Person must calculate the Credit Risk RWA for the free delivery transaction.
      3. For Derivatives (OTC and exchange-traded) and long settlement transactions, an Authorised Person is exposed to settlement risk. For Derivatives Contracts, the risk is that the price moves in an Authorised Person's favour so that it makes a book profit but at maturity the Authorised Person cannot realise that profit because the other party defaults.
      4. In cases of a system-wide failure of a settlement or clearing system, an Authorised Person need not calculate CRCOM on transactions remaining unsettled till the settlement or clearing system is brought back to normal operations.

    • PRU A4.6.1

      The Section applies in respect of items in both the Trading Book and Non-Trading Book.

    • PRU A4.6.2

      CRWs must be calculated on the Counterparty to the transaction, not on the Issuer of the Security.

    • PRU A4.6.3

      When calculating its Credit RWA, an Authorised Person must not include RWA arising from a transaction if it is a negative amount.

    • PRU A4.6.4

      CRW is applied in accordance with Section A4.3 except that the maximum CPW for an OTC Derivative is 50%.

    • Unsettled Transactions

      • PRU A4.6.5

        An Authorised Person must calculate the Credit RWA for transactions in which debt instruments, equities, foreign currencies and commodities (excluding repos, reverse repos and Securities or commodities lending/borrowing) remain unsettled after their due delivery dates, using the following formula:

        Credit RWA on Unsettled Transactions = E × the appropriate percentage from the second column in the table below:

        Number of business days after due settlement date Percentages used for calculation of Credit RWA on Unsettled Transactions
        0–4 0%
        5–15 100%
        16–30 500%
        31–45 750%
        46 or more 1000%

      • PRU A4.6.6

        If assets involved in the transaction are to be received by the Authorised Person and the transaction remains unsettled:

        E = max(MV-CV, 0)

        where MV is the market value of the assets and CV represents the contracted value for delivery of the assets.

      • PRU A4.6.7 PRU A4.6.7

        If assets involved in the transaction are to be delivered by the Authorised Person and the transaction remains unsettled:

        E = max(CV-MV, 0)

        • Guidance

          E is the price difference to which the Authorised Person is exposed, being the difference between the agreed settlement price for the debt instrument, equity, foreign currency or commodity in question and its current market value, where the difference could involve a loss for the firm.

    • Free delivery transactions

      • PRU A4.6.8

        An Authorised Person must calculate the Credit RWA in accordance with the table in Rule A4.6.11 for free delivery transactions in both the Trading and Non-Trading Book where it has:

        (a) delivered Securities or commodities before receiving payment;
        (b) paid for Securities or commodities before receiving the items purchased; or
        (c) entered into a foreign exchange contract undertaken in the spot market or contracted for forward settlement and has released funds to its Counterparty but has not yet received the funds in the other currency.

      • PRU A4.6.9 PRU A4.6.9

        If the settlement of the transaction is to be effected across a national border, Credit RWA needs to be calculated only when more than one business day has elapsed since the firm has made the relevant payment or delivery.

        • Guidance

          In respect of free delivery transactions referred to in Rule A4.6.9, if the dates when two payment legs are made are the same according to the time zones where each payment is made, they are deemed to have been settled on the same day.

      • PRU A4.6.10

        For a free delivery transaction an Authorised Person must determine its exposure E after the end of the first contractual payment or delivery date as follows:

        (a) if an Authorised Person has delivered Securities or Commodities or foreign exchange funds to a Counterparty and has not received payment:

        E = CV due to the Authorised Person

        (b) if an Authorised Person has made payment of CV to a Counterparty for commodities or Securities and has not received them:

        E = CV – MV of the Securities, commodities or foreign exchange funds due to it

      • PRU A4.6.11

        The Credit RWA in respect of free delivery transactions are to be calculated in accordance with the following table:

         

        Transaction stage Treatment
        Up to first contractual payment or delivery leg No calculation required
        From first contractual payment or delivery leg up to four business days after second contractual payment or delivery leg Treat as an exposure
        From five business days post contractual payment or delivery leg until extinction of the transaction Treat as an exposure with a risk-weight of 1000%

         

      • PRU A4.6.12

        An Authorised Person must treat an Exposure in accordance with the relevant provisions of Chapter 4.

      • PRU A4.6.13

        If the Authorised Person considers the total amount of the exposures resulting from free delivery transactions to be immaterial it may apply a risk weight of 100% to these exposures, except where a risk weight of 1000% is applied in accordance with Rule A4.6.11.

    • Derivatives and long settlement transactions – Standardised Approach to Counterparty Credit Risk (SA-CCR)

      • PRU A4.6.14

        The exposure at default (EAD) of Derivative transactions (OTC and exchangetraded) and long settlement transactions must be calculated in accordance with this Section unless the Authorised Person has been granted permission by the Regulator to use an internal model.

      • PRU A4.6.15 PRU A4.6.15

        EAD is to be calculated separately for each netting set. It is determined as follows:

        EAD = alpha* (RC + PFE)

        where:

        alpha = 1.4

        RC = the replacement cost calculated according to Rules A4.6.19 to A4.6.24

        PFE = the amount for potential future exposure calculated according to Rule A4.6.26

         

        • Guidance

          Details of how to net the PFCE are given in Rule A4.6.22.

      • PRU A4.6.16

        The replacement cost (RC) and the potential future exposure (PFE) components must be calculated differently for margined and unmargined netting sets. The EAD for a margined netting set is to be capped at the EAD of the same netting set calculated on an unmargined basis.

    • Netting Sets

      • PRU A4.6.17

        An Authorised Person may net transactions subject to any legally valid form of bilateral netting which results in legal substitution of one single payable/receivable amount for previous gross obligations.

      • PRU A4.6.18

        In every case in which netting is applied, the Authorised Person must demonstrate to the Regulator that it has the following in place:

        (a) A netting contract with the counterparty or other agreement which creates a single legal obligation, covering all included transactions, such that the Authorised Person would have either a claim to receive or obligation to pay only the net sum of the positive and negative mark-to-market values of included individual transactions in the event a counterparty fails to perform due to any of the following:
        (i) default,
        (ii) bankruptcy,
        (iii) liquidation, or
        (iv) similar circumstances.
        (b) Written and reasoned legal reviews that, in the event of a legal challenge, the relevant courts and administrative authorities would find the exposure of the Authorised Person to be such a net amount under:
        (i) The law of the jurisdiction in which the counterparty is chartered and, if the foreign branch of a counterparty is involved, then also under the law of the jurisdiction in which the branch is located;
        (ii) The law that governs the individual transactions; and
        (iii) The law that governs any contract or agreement necessary to effect the netting.
        (c) Proceduresto ensure that the legal characteristics of netting arrangements are kept under review in light of the possible changes in relevant law.

    • Calculation of RC for unmargined transactions

      • PRU A4.6.19

        An unmargined transaction is a transaction in which variation margin is not exchanged. Collateral other than variation margin may be present.

      • PRU A4.6.20

        RC for unmargined transactions is calculated in accordance with the following formula:

        RC = max{V – C; 0}

        where:

        V = the value of the derivative transactions in the netting set (constituted in accordance with Rule A4.6.18); and

        C = the haircut value of the net collateral held, calculated in accordance with Section A4.3.

         

      • PRU A4.6.21

        Derivative contracts with a one-way margining agreement in favour of the Authorised Person's counterparty must be treated as unmargined transactions.

    • Net Independent Collateral Amount

      • Guidance

        An Authorised Person may calculate the PFCE arising under OTC Derivative contracts on a net basis.

      • PRU A4.6.22

        The independent collateral amount (ICA) is (i) collateral (other than variation margin) posted by the counterparty that is available to the Authorised Person on default of the counterparty; and/or (ii) the Independent Amount parameter as defined in standard industry documentation.

      • PRU A4.6.23

        The net independent collateral amount (NICA) is any ICA posted by the counterparty less unsegregated collateral posted by the Authorised Person.

    • Calculation Of RC For Margined Transactions

      • PRU A4.6.24 PRU A4.6.24

        RC for margined transactions is calculated in accordance with the following formula:

        RC = max{V – C; TH + MTA – NICA; 0}

        where:

        V = the value of the derivative transactions in the netting set (constituted in accordance with Rule A4.6.18);

        C = the haircut value of the net collateral held, calculated in accordance with Section A4.3;

        TH = the positive threshold before the counterparty is required to send the Authorised Person collateral;

        MTA = the minimum transfer amount applicable to the counterparty;

        NICA = the net independent collateral amount.

        • Guidance

          (TH + MTA – NICA) represents the largest exposure that would not trigger a variation margin call. For example, without initial margin, the greatest exposure that would not trigger a variation call is the threshold plus any minimum transfer amount.

    • Potential Future Exposure

      • PRU A4.6.25

        The PFE consists of (i) an aggregate add-on component, which consists of add-ons calculated for each asset class and (ii) a multiplier that allows for the recognition of excess collateral or negative mark-to-market value for the transactions.

      • PRU A4.6.26

        PFE is calculated as follows:

        PFE = multiplier * AddOnaggregate

        where:

        AddOnaggregate = the aggregate add-on component; and 

        multiplier = a function of three inputs (V, C and AddOnaggregate), calculated in accordance with Rule A4.6.27.

      • PRU A4.6.27

        The multiplier input is calculated in accordance with the following formula:

        PRU_Ver06_A4_6_27.PNG

        where:

        exp(…) = the exponential function;

        Floor = 5%;

        V = the value of the derivative transactions in the netting set; and

        C = the haircut value of the net collateral held, calculated in accordance with Section A4.3.

    • General Steps For Calculating The Add-On

      • PRU A4.6.28

        For each transaction, the Authorised Person must identify the primary risk factor or factors and attribute the transaction to one or more of the five asset classes: interest rate, foreign exchange, credit, equity or commodity.

      • PRU A4.6.29 PRU A4.6.29

        The Authorised Person must determine the add-on for each asset class in accordance with the asset-class-specific formulae set out in A4.6.35A4.6.58.

        • Guidance

          Most derivative transactions have one primary risk driver, defined by the reference underlying instrument (e.g. an interest rate curve for an interest rate swap, a reference entity for a credit default swap, a foreign exchange rate for an FX call option etc.).

    • Formulae And Parameters Common To All Asset Classes

      • PRU A4.6.30

        The following formulae and adjustments are used in the determination of the add-ons for all asset classes.

    • Supervisory Delta Adjustment: δi

      • PRU A4.6.31 PRU A4.6.31

        The Authorised Person must include the following supervisory delta adjustments in the calculation of the relevant add-on where relevant.

        δi Long in the primary risk
        factor
        Short in the primary risk
        factor
        Instruments that are
        not options or CDO
        tranches
        +1 -1
        δi Bought Sold
        Call options
        Put options
        With the following parameters:

        Pi = underlying price (spot, forward, average etc.)

        Ki = strike price

        Ti = latest contractual exercise date of the option

        The supervisory volatility σi of an option is specified on the basis of the supervisory factor applicable to the trade in accordance with the table set out in A4.6.34.

        δi Purchased (long protection) Sold (short protection)
        CDO tranches
        With the following parameters:

        Ai = attachment point of the CDO tranche

        Di = detachment point of the CDO tranche

        • Guidance

          "Long in the primary risk factor" means that the market value of the instrument increases, whereas "short in the primary risk factor" means that the market value of the instrument decreases when the value of the primary risk factor increases. The symbol Φ in these equations represents the standard normal cumulative distribution function.

    • Time Risk Horizons – Unmargined Transactions

      • PRU A4.6.32 PRU A4.6.32

        The Authorised Person must calculate the maturity factor (MFi) of unmargined transactions in accordance with the following formula:

        where Mi is the remaining maturity of the transaction, floored at ten business days.

        • Guidance

          The formula requires that the minimum time risk horizon for unmargined transactions is the lesser of one year and the remaining maturity of the derivative contract, floored at ten business days.

    • Time Risk Horizons – Margined Transactions

      • PRU A4.6.33

        The Authorised Person must calculate the MFi of margined transactions in accordance with the following formula:

        The appropriate margin period of risk (MPORi) is determined in accordance with the following table:

        Transaction Type Minimum Margin Period of Risk (MPORi)
        Non-centrally-cleared derivative transactions subject to daily margin agreements Ten business days
        Centrally cleared derivative transactions subject to daily margin agreements Five business days
        Netting sets consisting of 5,000 or more transactions that are not with a central counterparty Twenty business days
        Netting sets with outstanding disputes Double the MPORi for the relevant category of transaction

    • Supervisory factors, correlation and supervisory option volatilities

      • PRU A4.6.34

        Supervisory factors are specific to each asset class. The Authorised Person must refer to the table below to determine the supervisory factor relevant to their determination of the add-on for their particular asset class in accordance with the asset-class-specific formulae set out in Rules A4.6.35 to A4.6.58.

        Asset Class Subclass Supervisory factor SF (%) Correlation ρ (%) Supervisory option volatility σ (%)
        Interest rate   0.50 n/a 50
        Foreign exchange   4.0 n/a 15
        Credit, single name (where CQG represents Credit Quality Grade) CQG 1 0.38 50 100
        CQG 2 0.42 50 100
        CQG 3 0.54 50 100
        CQG 4 1.06 50 100
        CQG 5 1.6 50 100
        CQG 6 6.0 50 100
        Credit, index Investment Grade 0.38 80 80
        Non-Investment Grade 1.06 80 80
        Equity, single name   32 50 120
        Equity, index   20 80 75
        Commodity Electricity 40 40 150
        Oil/Gas 18 40 70
        Metals 18 40 70
        Agricultural 18 40 70
        Other 18 40 70

    • Trade Level Adjusted Notional – Interest Rate (di (IR)) And Credit Derivatives (di (Credit))

      • PRU A4.6.35

        For interest rate and credit derivatives, the trade-level adjusted notional is the product of the trade notional amount, converted to the domestic currency, and the supervisory duration (SDi):

        Trade-level adjusted notional = Trade notional amount * SDi

      • PRU A4.6.36

        SDi is determined in accordance with the following formula:

        𝑆𝐷𝑖=exp(‐0.05𝑆𝑖)−exp(‐0.05𝐸𝑖)/0.05

        where 𝑆𝑖 and 𝐸𝑖 are the start and end dates, respectively, of the time period referenced by the interest rate or credit derivative, floored by ten business days.

    • Add - On For Interest Rate Derivatives

      • PRU A4.6.37

        The add-on for interest rate derivatives is the sum of the add-ons for each hedging set of interest rate derivatives transacted with a counterparty in a netting set.

      • PRU A4.6.38

        Interest rate derivatives consist of a separate hedging set for each currency. Interest rate derivatives are divided into three time 'buckets' as follows: less than or equal to one year, greater than one year and lessthanor equal to five years, and more than five years.

      • PRU A4.6.39

        The add-on for a hedging set of interest rate derivatives is calculated in two steps:

      • Step 1

        • PRU A4.6.40 PRU A4.6.40

          The effective notional is calculated in accordance with the following formula:

          where:
          i ε (Ccyj, MBk) refers to trades of currency j that belong to maturity bucket k.

          • Guidance

            The effect of this formula is that the effective notional for each time bucket and currency is the sum of the trade-level adjusted notional amounts multiplied by the supervisory delta adjustments and the maturity factor.

      • Step 2

        • PRU A4.6.41

          The Authorised Person must aggregate across maturity buckets for each hedging set in accordance with the following formula:

        • PRU A4.6.42

          The Authorised Person must then determine the hedging set level add-on in accordance with the following formula:

        • PRU A4.6.43

          The Authorised Person must then aggregate the interest rate derivative add-on across hedging sets by simple summation, as follows:

    • Add - On For Credit Derivatives

      • A4.6.44 PRU A4.6.44

        All credit derivatives referencing the same entity may be offset fully to form an entity-level effective notional amount:

        where i ε Entityk refers to trades of Entityk.

        • Guidance

          The effect of this formula is that the effective notional for each entity is the sum of the trade-level adjusted notional amounts multiplied by the supervisory delta adjustments and the maturity factor.

      • PRU A4.6.45

        The add-on for all positions referencing the entity is determined in accordance with the following formula:

        𝐴𝑑𝑑𝑂𝑛(𝐸𝑛𝑡𝑖𝑡𝑦𝑘) = 𝑆𝐹𝑘(𝐶𝑟𝑒𝑑𝑖𝑡)∗ 𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒𝑁𝑜𝑡𝑖𝑜𝑛𝑎𝑙𝑘(𝐶𝑟𝑒𝑑𝑖𝑡)

        where SFk is the supervisory factor for the credit asset class, determined in accordance with the table set out in A4.6.36.

      • PRU A4.6.46

        The cumulative add-on for the credit derivatives hedging set is determined in accordance with the following formula:

        where ρ (credit)k is the appropriate correlation factor corresponding to the entity k, determined in accordance with the table set out in A4.6.36.

    • Trade Level Adjusted Notional – Foreign Exchange Derivatives

      • A4.6.47 PRU A4.6.47

        The adjusted notional of foreign exchange derivatives is defined as the notional of the foreign currency leg of the contract, converted to the domestic currency.

        • Guidance

          If both legs of the foreign exchange derivative are denominated in currencies other than the domestic currency, the notional amount of each leg is converted to the domestic currency and the leg with the larger domestic currency value is the adjusted notional amount.

    • Add - On For Foreign Exchange Derivatives

      • A4.6.48 PRU A4.6.48

        The effective notional for foreign exchange derivatives is calculated in accordance with the following formula:

        where i ε HSj refers to trades of hedging set HSj

        • Guidance

          The effective notional for each currency pair, given by the above formula, is the sum of the trade-level adjusted notional amounts multiplied by the supervisory delta adjustments and the maturity factor.

      • PRU A4.6.49

        The Authorised Person must calculate the hedging set level add-on in accordance with the following formula:

      • PRU A4.6.50

        The Authorised Person must then aggregate the foreign exchange derivative addon across hedging sets by simple summation, as follows:

    • Trade Level Adjusted Notional – Equity And Commodity Derivatives

      • PRU A4.6.51

        For equity and commodity derivatives, the adjusted notional is defined as the product of the current price of one unit of the stock or commodity and the number of units referenced by the trade.

    • Add - On For Equity Derivatives

      • A4.6.52 PRU A4.6.52

        The Authorised Person must determine the effective notional value of an equity derivative transaction referenced to an entity in accordance with the following formula:

        • Guidance

          The effective notional for each entity, calculated in accordance with the above formula, is the sum of the trade-level adjusted notional amounts multiplied by the supervisory delta adjustments and the maturity factor.

      • PRU A4.6.53

        The Authorised Person must calculate the add-on for all positions referencing entity k and its effective notional in accordance with the following formula:

      • PRU A4.6.54

        The Authorised Person must calculate the add-on for the hedging set in accordance with the following formula:

        where ρk (equity) is the appropriate correlation factor corresponding to the entity k, determined in accordance with the table set out in A4.6.34.

    • Add - On For Commodity Derivatives

      • A4.6.55 PRU A4.6.55

        The Authorised Person must determine the effective notional value of a commodity derivative transaction in a commodity of a particular type listed in A4.6.34 in accordance with the following formula:

        where i εTypek j refers to trades of commodity type k in hedging set j.

        • Guidance

          The effective notional for each commodity derivative, calculated in accordance with the above formula, is the sum of the trade-level adjusted notional amounts multiplied by the supervisory delta adjustments and the maturity factor.

      • PRU A4.6.56

        The Authorised Person must determine the add-on for all commodity derivatives of commodity type k in accordance with the following formula:

      • PRU A4.6.57

        The Authorised Person must determine the add-on for its commodity hedging set in accordance with the following formula:

         

        where ρj (com) is the appropriate correlation factor, determined in accordance with the table in A4.6.34, for the hedging set j.

      • PRU A4.6.58

        The Authorised Person must determine the add-on for its commodity asset class in accordance with the following formula: