Part 2 – Methodology

In our first article, “SA-CCR Final Rule – Are You Prepared? we introduced the approach for measuring a bank’s Exposure at Default (EAD) and its two components, the replacement cost (RC) and the potential future exposure (PFE). We also outlined the benefits of the SA-CCR approach in recognizing the risk-reducing effect of netting and hedging sets. We will go into a bit more detail on the SA-CCR methodology in this part of the series.

The replacement cost (RC) reflects the loss that would occur if a counterparty were to default, i.e., the positive mark-to-market (MtM) of the derivative trades at the netting set level less collateral.

The potential future exposure (PFE) component consists of a multiplier that allows for the partial recognition of excess collateral or negative MtM values and an “aggregate add-on,” which is the total of separate asset-class level add-ons.

First, let us define a few key concepts prevalent within the SA-CCR approach:

A netting set is a group of transactions with a single counterparty subject to a legally enforceable bilateral netting arrangement and for which netting is recognized for regulatory capital purposes.

A margin agreement is a contractual agreement or provisions to an agreement under which one counterparty must supply a variation margin to a second counterparty when the second counterparty’s exposure to the first counterparty exceeds a specified level.

A hedging set is a set of transactions within a single netting set within which full or partial offsetting is recognized to calculate the PFE add-on in each asset class.

Most of the derivatives transactions within the financial institutions are governed by the agreements arranged bilaterally with zero threshold, daily collateralized requirements. Broader implementation of variation margin (VM) documentation occurred back in 2017 in what was known in the industry as “VM big bang”.

Here is an outline of the add-on calculation approaches for the asset classes in the SA-CCR structure:

Interest rate (IR) derivatives: different hedging sets relate to IR derivatives in the same fundamental currency (e.g., USD, EUR, CHF). Hedging sets are further subdivided into maturity buckets. Long and short positions can fully offset each other within the same hedging set and maturity bucket, whereas partial offsetting is acknowledged across maturity buckets.

Foreign exchange (FX) derivatives: different hedging sets correspond to FX derivatives with the same FX currency pair (e.g., USD/EUR, CHF/EUR). Long and short positions in the same FX currency pair can completely offset each other while offsetting across FX currency pairs is not recognized.

Credit derivatives: a single hedging set is defined for all credit derivatives. Full offsetting is recognized for derivatives referencing the same entity, name, or, whereas partial offsetting is allowed across different entities.

Equity derivatives: a single hedging set is well-defined for all equity derivatives. Full offsetting is recognized for derivatives referencing the same entity, name, or index, whereas partial offsetting is allowed across different entities.

Commodity derivatives: four hedging sets are defined: energy, metals, agriculture, and others. Full offsetting is recognized within the same hedging set for derivatives referencing the same commodity, while partial offsetting is allowed for derivatives referencing different commodities. Offsetting between hedging sets is not permitted.

The add-on for the transactions under a netting agreement corresponds to the total of the add-ons for each so-called “asset class.” The method for calculating the add-ons for each “asset class” was developed based on the concept of the “hedging set.”

A hedging set under the SA-CCR is a subset of transactions within an asset class with similar attributes. Depending on the asset class, the results of netting buy and sell positions within a hedging set are partially or wholly offset. The value of the add-on is thus dependent on the number of hedging sets within an asset class.

The effective notional must be calculated at the individual trade level, with slight variation between asset classes. This is a measure of the sensitivity of the trade to movements in underlying risk factors and is calculated as the product of the three components: (i) the adjusted notional – measure of the size of the trade and (ii) the maturity factor – takes account of the time-period using the margin period of risk (MPOR), subject to specified floors and (iii) the supervisory delta.  The supervisory delta is used to ensure that the effective notional reflects the transaction’s direction and considers whether the trade has a non-linear relationship (e.g., options) with the underlying risk factor, utilizing the supervisory provided volatility parameter.

The SA-CCR calculation manages to capture the risk-reducing effect of cross-product netting. However, the segmentation into the different asset classes and hedging sets mean that the diversification benefit is more restricted than under IMM, where MtM offsets can be recognized across the entire netting set. Also, the SA-CCR collateral multiplier only allows for a partial recognition of over-collateralization (e.g., initial margin) and is floored at 5% (no amount of collateral can drive down the exposure to zero).

SA-CCR is essentially a risk-sensitive framework that extracts advanced risk measurement concepts into easier to implement formulations. The implementation will require a considerable effort that involves all corners of a financial institution – the front office, risk management, finance, collateral management, and technology – who will need to work together to establish the infrastructure and cohesive processes. Furthermore, successful implementation requires a full understanding of the hedging set concept and the margining processing under SA-CCR. The PFE add-on component’s computation is the most complex, as it varies widely depending on the asset class and subclass, collateralization, margin set, and netting set considered.

Read the next part of this series, where we explore the challenges banks face complying with the SA-CCR framework

Written by: Safder Dhirani, Regulatory Consultant