Shearman & Sterling LLP | Financial Regulatory Developments Focus | European Banking Authority Launches Consultation on Technical Standards for Counterparty Credit Risk
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  • European Banking Authority Launches Consultation on Technical Standards for Counterparty Credit Risk
    05/02/2019
    The European Banking Authority has launched a consultation on the Regulatory Technical Standards that it is developing to govern certain aspects of counterparty credit risk in derivatives transactions. The EBA has been mandated to produce the RTS under the current draft of the Capital Requirements Regulation 2. The consultation runs until August 2, 2019. A public hearing will also take place at the EBA premises in Paris on June 17, 2019 from 15:00 - 17:00 CET. Parties interested in attending should register by May 28, 2019.

    CRR2 aims to tackle weaknesses in existing EU regulation, in part by taking into account reforms published by global standard setters. These reforms include the Basel Committee on Banking Supervision's method for calculating the exposure value of derivatives exposures, known as the "Standardised Approach for Counterparty Credit Risk". The Standardised Approach for Counterparty Credit Risk is intended to address the shortcomings of existing calculation methods to ensure parties are adequately protected in the event of default by a counterparty to a derivatives transaction.

    CRR2 has focused on the following measures in implementing the Standardised Approach to Counterparty Credit Risk:
    • Replacing existing categories of default exposure with two new categories – "replacement cost" and "potential future exposure"; "replacement cost" represents the loss that would occur if a counterparty defaults and the transactions are closed out immediately, while "potential future exposure" measures the potential change in the transaction value over a one-year period;
    • Including an additional "add-on" amount in the potential future exposure calculation, which is determined by the "risk category" assigned to the particular transaction; the risk categories relate to the type of derivative in question, and are listed in CRR2 as: (i) interest rate risk; (ii) foreign exchange risk; (iii) credit risk; (iv) equity risk; (v) commodity risk and (vi) other risk;
    • Determining how risk categories are assigned to each set of derivative transactions by reference to the key risk drivers of each transaction (a process known as "mapping").

    CRR2 sets out the broad parameters implementing each of the above measures, but specifies that the EBA should develop technical standards which define in more detail how parties should calculate and comply with them. In its consultation, the EBA sets out the following:
     
    1. A methodology for the "mapping" of risk categories using risk drivers. The EBA proposes a three-stage approach by which parties may determine the primary risk driver of a derivative transition:
      1. First approach: a qualitative approach that identifies derivative transactions that clearly have only one material risk driver;
      2. Second approach: failing the first approach, a qualitative and quantitative approach that identifies one or more risk categories for derivative transactions with a more complex set of risk drivers; and
      3. Third approach: in the event the first and second approach are not sufficient, a fallback approach, which involves allocation of the derivative transaction to all risk categories corresponding to all risk drivers (whether material or not) of the derivative transaction.
    2. Formulas for computing certain aspects of derivative transactions. Derivatives transactions may be offset against each other if they depend on the same or similar risk drivers. To establish the extent to which a transaction depends on a given risk driver, a "supervisory delta" (i.e. formula) must be applied. The EBA has proposed a version of this formula to deal with mapping derivatives transactions to the interest rate category that is compatible with negative interest rates, as well as a method for determining whether a transaction represents a long or short risk driver.

    Given that CRR2 has not yet been published in the Official Journal of the European Union, the EBA states that the draft RTS may be amended further following the consultation to take into account any changes to CRR2.

    View the EBA's consultation paper.

    View the EBA's announcement of its consultation.

    View the registration page for the EBA's public hearing.

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