Treatment of credit derivatives in the trading book
An ADI must determine the capital to be held against credit derivative instruments in the trading book in accordance with this Attachment.
An ADI must include in its trading book total-rate-of-return swaps, except those that have been transacted to hedge a banking book credit exposure in accordance with the requirements in Attachment J to APS 112. An ADI must include open short positions in credit derivatives in its trading book. APRA may, in writing, exempt the ADI from this requirement on a one-off approval basis. When determining whether other credit derivative transactions should be allocated to the banking or trading book, the ADI must consider the trading book requirements outlined in Attachment A to this Prudential Standard. Before including other credit derivative transactions (i.e. transactions other than total-rate-of-return swaps and open short positions) in its trading book, the ADI must undertake a written assessment setting out its reasons for doing so. The ADI must provide its written assessment to APRA upon request. APRA may make a determination requiring the ADI to allocate the transaction to the banking book where APRA considers that this is more appropriate given the nature of the transaction.
Application
This Attachment applies to single name credit-default swaps, certain total-rate-of-return swaps, cash-funded credit-linked notes and first- and second-to-default baskets. An ADI that transacts more complex credit derivatives that fall outside the scope of this Attachment must, prior to execution of the relevant credit derivative contract, undertake a written assessment of the appropriate regulatory capital treatment for the transaction. The ADI must provide its written assessment to APRA upon request. The ADI must apply the treatment set out in its written assessment unless APRA determines, in writing, an alternative methodology for calculating the regulatory capital treatment.
Where APRA considers that an ADI is undertaking significant credit derivative activity, as either a purchaser or seller of protection, such that large exposures and concentrations are a potential concern, APRA may, in writing, require the ADI to adopt an alternative capital treatment to that described in this Attachment.
An ADI may use either the standard method or, with APRA’s approval, either an internal model or other method to measure the general market risk and specific risk charges on credit derivative positions in the trading book. This Attachment outlines the calculation of the capital charge for credit derivatives under the standard method. An ADI that wishes to use an internal risk measurement model to generate the capital requirement must obtain APRA’s written approval.
General principles - General market risk
An ADI that uses the standard method must treat credit derivatives based on a single reference entity in the same way as interest-rate-related derivatives (refer to Attachment B) for the purposes of calculating a general market risk capital charge. Each credit derivative instrument must be broken down into a notional debt instrument, to reflect the interest rate or fee-paying leg (if regular fees are paid under the terms of the contract) and, where applicable, a position in the reference obligation.
An ADI must include these positions in the maturity ladder applicable to the currency of the cash flows and report at their market values.
General principles - Specific risk
Where the credit-event payment is defined as the par value of the reference obligation less its recovery value (i.e. the credit derivative is cash settled), an ADI must report for specific risk purposes the par value of the reference obligation. Where the credit-event payment is defined as a fixed amount, the ADI must report the fixed amount. Where there is payment of the par value of an obligation in exchange for its physical delivery, the ADI must report the par value of the obligation. In the latter two cases, the amount reported must reflect a position in the reference entity with maturity equal to the term to maturity of the credit derivative.
Credit-default swaps
If an ADI is a protection buyer in a credit-default swap, it must enter into the maturity ladder a short position in a notional debt instrument, where regular interest or fee cash flows are to be paid, to reflect the general market risk associated with those cash flows. The ADI must also calculate a specific risk capital charge on a short position in the reference entity.
If an ADI is a protection seller in a credit-default swap, it must enter into the maturity ladder a long position in a notional debt instrument, where regular interest or fee cash flows are to be received, to reflect the general market risk associated with those cash flows. The ADI must also calculate a specific risk capital charge on the long position in the reference entity.
Total-rate-of-return swaps
If an ADI is a protection buyer in a total-rate-of-return swap, it must enter into the maturity ladder a position in a notional debt instrument, where regular interest or fee cash flows are to be exchanged, to reflect the general market risk associated with those cash flows. General market risk and specific risk capital charges must also be calculated on the short position in the reference obligation.
If an ADI is a protection seller in a total-rate-of-return swap, it must enter into the maturity ladder a position in a notional debt instrument, where regular interest or fee cash flows are to be exchanged, to reflect the general market risk associated with those cash flows. General market risk and specific risk capital charges must also be calculated on the long position in the reference obligation.
Cash-funded credit‑linked notes
If an ADI is a protection buyer in a credit‑linked note, it must enter into the maturity ladder a short position in the underlying interest rate instrument for general market risk purposes. The ADI must also calculate a specific risk capital charge on the short position in the reference entity.
If an ADI is a protection seller in a credit‑linked note, it must enter into the maturity ladder a long position in the underlying interest rate instrument for general market risk purposes. The ADI must calculate a specific risk capital charge on the long position in the reference entity and the long position in the underlying interest rate instrument (i.e. the long position in the protection buyer).
Nth-to-default basket credit derivatives
If an ADI is a protection buyer in a first- or second-to‑default basket, it must enter into the maturity ladder a short position in a notional debt instrument, where regular interest or fee cash flows are to be paid, to reflect the general market risk associated with those cash flows.
If an ADI is a protection seller in a first- or second-to‑default basket, it must enter into the maturity ladder a long position in a notional debt instrument, where regular interest or fee cash flows are to be received, to reflect the general market risk associated with those cash flows.
An ADI must determine the capital charge for specific risk for an nth-to-default credit derivative as follows:
The capital charge for specific risk for a first-to-default credit derivative is the lesser of (1) the sum of the specific risk capital charges for the individual reference credit instruments in the basket, and (2) the maximum possible credit event payment under the contract. Where an ADI has a risk position in one of the reference credit instruments underlying a first-to-default credit derivative and this credit derivative hedges the ADI’s risk position, the ADI is allowed to reduce, with respect to the hedged amount, both the capital charge for specific risk for the reference credit instrument and that part of the capital charge for specific risk for the credit derivative that relates to this particular reference credit instrument. Where an ADI has multiple risk positions in reference credit instruments underlying a first-to-default credit derivative this offset is allowed only for that underlying reference credit instrument having the lowest specific risk capital charge.
The capital charge for specific risk for an nth-to-default credit derivative with n greater than one is the lesser of (1) the sum of the specific risk capital charges for the individual reference credit instruments in the basket but disregarding the (n-1) obligations with the lowest specific risk capital charges; and (2) the maximum possible credit event payment under the contract. For nth-to-default credit derivatives with n greater than 1 no offset of the capital charge for specific risk with any underlying reference credit instrument is allowed.
If an ADI is a protection seller, then where a first- or second-to-default basket product has an external credit assessment[47] from an ECAI, the ADI must calculate the specific risk capital charge using the rating of the derivative and apply the respective securitisation risk weights as specified in paragraphs 12 or 13 of Attachment B, as applicable.
The capital charge against each net nth-to-default credit derivative position applies irrespective of whether the ADI has a long or short position (i.e. obtains or provides protection).
Specific risk offsetting
An ADI may recognise full allowance for offsetting when the values of two legs (i.e. long and short) always move in the opposite direction and broadly to the same extent. This occurs where:
the two legs consist of completely identical instruments; or
a long cash position is hedged by a total rate of return swap (or vice versa) and there is an exact match between the reference obligation and the underlying exposure (i.e. the cash position).[48] In these cases, specific risk capital requirements do not apply to either side of the position.
An ADI may recognise an offset of 80 per cent when the value of two legs (i.e. long and short) always moves in the opposite direction but not broadly to the same extent. This would be the case when a long cash position is hedged by a credit-default swap or a credit-linked note (or vice versa) and there is an exact match in terms of the reference obligation, the maturity of both the reference obligation and the credit derivative, and the currency of the underlying exposure. In addition, key features of the credit derivative contract (e.g. credit-event definitions, settlement mechanisms) must not cause the price movement of the credit derivative to materially deviate from the price movements of the cash position. To the extent that the transaction transfers risk (i.e. taking account of restrictive payout provisions such as fixed payouts and materiality thresholds), an 80 per cent specific risk offset may be applied to the side of the transaction with the higher capital charge, while the specific risk requirement on the other side is zero.
An ADI may recognise a partial offset when the value of the two legs (i.e. long and short) usually moves in the opposite direction. This occurs where:
the position is captured in paragraph 18(b) of this Attachment but there is an asset mismatch[49] between the reference obligation and the underlying exposure; nonetheless, the position meets the requirements for an asset mismatch to be allowed for credit risk mitigation purposes as set out in Attachment J to APS 112; or
the position is captured in paragraphs 18(a) or 19 of this Attachment but there is a currency or maturity mismatch[50] between the credit protection and the underlying asset; or
the position is captured in paragraph 19 of this Attachment but there is an asset mismatch between the cash position and the credit derivative. However, the underlying asset is included in the (deliverable) obligations in the credit derivative documentation.
In each of these situations, rather than adding the specific risk capital requirements for each side of the transaction, an ADI may apply only the higher of the two capital requirements.
If an instrument does not comply with paragraphs 18, 19 or 20 of this Attachment, the ADI must assess a specific risk capital charge against both sides of the position.