Bail-in – Valuation of Derivative Contracts
THE DELTA REPORT
A Commission Delegated Resolution (EU) 2016/1401 ("CDRVD") on the valuation of derivatives for the purpose of bail-in pursuant to Article 49(4) of the Bank Recovery and Resolution Directive 2014/59/EU (the "BRRD") was published in the Official Journal of the European Union on 23 August 2016. The CDRVD enters into force on 12 September 2016. The CDRVD is substantially similar to the regulatory technical standard adopted by the European Commission (the "Commission") on 23 May 2016.
The BRRD bail-in requirement applies to EU incorporated banks and large investment firms and their EU incorporated holding companies and their EU subsidiaries (including non-EU branches of EU incorporated firms). The BRRD bail-in requirement does not apply to non-EU incorporated firms or their EU branches.
Pursuant to Article 63(1)(e) and (f) of the BRRD, a national resolution authority ("RA") may write down or convert into equity "eligible liabilities" of an institution in resolution ("IIR"). Liabilities arising under derivative contracts ("DCs") if: (i) not excluded by: (a) the provisions of Article 44(2) of the BRRD;25 or (b) the RA under Article 44(3) of the BRRD in exceptional circumstances (see further below); or (ii) unsecured or uncollateralised (but only to the extent such DCs are unsecured or uncollateralised) are "eligible liabilities" potentially subject to a bail-in (such derivative liabilities are referred to herein as "PBIDLs"). Whilst any write down or conversion of PBIDLs applies only on close-out of the relevant DCs, Article 63(1)(k) of the BRRD gives the RA the ability to terminate and close out any DCs (whether collateralised or not) for the purposes of bail-in.
It is noteworthy that the universe of PBIDLs potentially subject to bail-in should decline due to:
(a) the implementation of mandatory clearing requirements (resulting in mandated margin requirements) pursuant to EMIR;26 and/or
(b) the implementation of collateralisation requirements applicable to uncleared derivatives pursuant to EMIR; and
(c) existing margin rules imposed by central counterparties ("CCPs") relating to existing cleared transactions (collectively, "Collateralised PBIDLs").
Collateralised PBIDLs are only subject to bail-in to the extent of a net balance being due (i.e. the value of the DC liability is greater than the value of the collateral/security/margin). However, in normal market conditions, in the case of cleared transactions, it is not expected that the default of a clearing member would result in losses in excess of posted collateral/margin.
On a case by case basis, a RA may exclude PBIDLs from bail-in in exceptional circumstances. As set out in Article 44(3) of the BRRD, such exceptional circumstances include: (a) where the bail-in of PBIDLs would cause such a value destruction that the losses borne by other creditors would be higher than if those PBIDLs were excluded from bail-in; and (b) where it is not possible to conduct a bail-in within a reasonable time. Pursuant to Article 44(11) of the BRRD, the Commission adopted a delegated act in February 2016 specifying the circumstances in which PBIDLs could be excluded from bail-in. See Commission Delegated Regulation (EU) 2016/860 which provides (in Recital 5 thereto) that the ability to exclude PBIDLs from the operation of the bail-in tool should be used to the minimum extent necessary.
Close-out and Netting
The BRRD lays down the parameters for valuing PBIDLs as the first step in the bail-in process. Article 49(2) of the BRRD provides that the bail-in tools only apply after the PBIDLs have been closed out. As such, RAs have the power to terminate and close out PBIDLs (that are not otherwise excluded). Further, Article 49(3) of the BRRD requires that, where PBIDLs are subject to a netting agreement, the PBIDLs are to be determined on a net basis in accordance with the provisions of the netting agreement.
Determination of Close-out Amounts
As a starting point, the RA is required to notify the counterparty ("IIRCP") of the termination and close-out of the DCs at the date and time specified in the notice, but which may also be immediate.27 The IIRCP has a set period as set out in the notice to provide evidence of "commercially reasonable replacement trades".28 The notice may also specify criteria by which the RA will assess whether any replacement trades are commercially reasonable.29 This set period may be changed by the RA by notice to the IIRCP.30
If the IIRCP is able to provide evidence of "commercially reasonable replacement trades", the valuer (being an independent person appointed in accordance with Article 36 of the BRRD or, if this is not possible, the RA) is required to determine the close-out amounts at the prices of those replacement trades.31 A "commercially reasonable replacement trade" is defined in the CDRVD to mean a "replacement trade entered into on a netted risk exposure basis, on terms consistent with common market practice and by making reasonable efforts to obtain best value for money".32
If the IIRCP fails to provide evidence of such replacement trades within the set period or the valuer considers the replacement trades to be on non-commercially reasonable terms, the RA may determine such valuation using:33
(a) mid-market end-of-day prices in line with the usual business practices of the IIR at the point in time of valuation;
(b) the mid-to-bid or mid-to-offer spread, depending on the direction of the netted risk position; and
(c) adjustments to these prices and spreads where necessary to reflect market liquidity (for the DCs in question), exposure size relative to market depth and model risk.
For the purposes of determining the close-out amount, the valuer is required to consider "a full range of available and reliable data sources" and may rely on "observable market data", "internal models", "independent price verification" (pursuant to the Capital Requirements Regulation),34 "quotes from market-makers" and "data provided by counterparties".35 If the DC is centrally cleared, values or estimates from CCPs can be used.36
Article 5(1) of the CDRVD requires the close-out amount to reflect the cost the IRRCP would incur to replace the economic equivalent of the terminated DCs "including the option rights of the parties in respect of those contracts".
The early termination amount determined by the valuer is the sum of the calculated close-out amount for all transactions in the netting set, plus any unpaid amounts, collateral or other amounts due from the IIR to its IIRCP, less any such amounts due to the IIR from the IIRCP.37
Article 4 of the CDRVD provides that the valuer must determine a single amount payable by the IIR or by the IIRCP as a result of the close-out of all DCs in a netting set thus protecting netting arrangements on a bail-in of DCs. A netting set is defined as "a group of contracts subject to a netting arrangement as defined in Article 2(1)(98) of Directive 2014/59/EU."38
Article 49 of the BRRD requires the European Banking Association (the "EBA") to set out methodologies for comparing the value destruction caused by closing out DCs with the amount of losses that would be absorbed by those PBIDLs on bail-in. This methodology is set out in Article 2 of the CDRVD. Essentially, the RA is required to determine as a result of close-out:39
(a) the proportion of PBIDLs not exempt from bail-in and valued as part of the Article 36 valuation, within all "equally-ranked" liabilities multiplied by the total losses expected to be borne by all equal ranked liabilities (including the PBIDLs);40 and
(b) the expected value destruction as the sum of the following items:41
(i) the risk of increased claims from IIRCPs to reflect re-hedging costs;42
(ii) the expected cost to the IIR of establishing hedges for open exposures to maintain an acceptable risk profile in accordance with the resolution strategy (such cost to be estimated by considering initial margin requirements and prevailing bid-offer spreads);43
(iii) valuation impairments to underlying assets linked to the DCs being closed-out, impact on funding costs, income levels or other reductions to franchise value;44 and
(iv) any precautionary buffer against adverse effects of close-out such as cost of errors or disputes.45
Once these amounts are determined, they are to be compared prior to any decision being taken to close out the DCs.46 If the expected losses from the close-out exceed the share of PBIDLs available for bail-in, the RA can exempt the PBIDLs from bail-in under Article 44(3) of the BRRD.
The general valuation method described above does not apply to centrally-cleared derivatives in circumstances where the IIR is a clearing member facing a CCP.47
CCPs are required under EMIR to have in place procedures for the default of a clearing member. Such procedures will typically include (as a first step) the CCP porting the IIR's cleared trades to another clearing member and, failing that, an auction of the IIR's trades amongst the other clearing members, the use of any collateral posted by the IIR and the use of default fund contributions. As any collateral posted by the IIR in accordance with the CCP's rules should be sufficient to cover the IIR's liability to the CCP, any bail-in right in respect of uncollateralised liabilities is unlikely to occur. In the case of a DC between the IIR and a CCP, the CDRVD uses the CCP's procedures for close-out of cleared derivatives to determine the relevant value.48 The RA is required to notify the CCP and the CCP's competent authority of the decision to close out the DC and to agree with them a deadline by which the CCP must provide the valuation of the early termination amount.49 The deadline may be changed by the RA.50 If the CCP fails to provide a valuation by the deadline, or the valuation by the CCP is not in line with the CCP's default procedures, the RA may determine that the valuation methods described in the CDRVD for the valuation of non-cleared derivatives will apply.51 Such a valuation may be made on a provisional basis, and an ex-post adjustment can be made.52
Valuations of DCs which are not based on the CCP's default procedure are only for resolution purposes and do not otherwise not affect the CCP's contractual and rulebook obligations.
Timing of Close-out and Valuation
The valuer must determine the value of PBIDLs at the following point in time:53
(a) where the valuer determines the close-out amount (i) on the basis of commercially reasonable replacement trades provided by the IIRCP, at the date and time of such replacement trades;54 or (ii) in accordance with CCP default procedures, at the date and time the early termination amount is determined by the CCP;55 and
(b) in all other cases, the close-out date, or where that would not be commercially reasonable, the date and time at which a market price is available for the underlying asset.56
Where a provisional valuation is made, the determination of the close-out value can be made earlier than the points in time specified above, based on the observable market data available at the time.57 The RA can request the valuer to update a provisional valuation at any time to reflect market developments or replacement trades, and where this evidence is available by the time close-out takes effect, it will be included in the definitive valuation under Article 36 of the BRRD.58 The RA may then either adjust the treatment of creditors on bail-in, or provide compensation on the basis of the BRRD Article 74 valuation.
Similarly, if the valuer makes an early determination in respect of DCs entered between an IIR (which is a clearing member) and a CCP, the valuer must take account of estimates of expected losses provided by the CCP.59 Such estimates must be updated if definitive termination values are provided by the CCP prior to the agreed deadline.60
Points to Note
Netting set: the protection provided by Article 4 of the CDRVD to "netting sets" does not apply to netting in the case of other non-DCs (such as repurchase and stock lending transactions) which also rely on close-out netting under master agreements. Although such non-DCs are typically collateralised (and therefore not eligible for bail-in to the extent secured or collateralised), such non-DCs would otherwise be eligible for bail-in to the extent there is or would be a net amount payable by the IRR, after taking account of any collateral or security. Counterparties to such non-DCs will need to rely on the no creditor worse off ("NCWO") principle to ensure that such non-DC liabilities are treated on a net basis for bail-in purposes.61
Cross product netting: as mentioned above, the protection provided by Article 4 of the CDRVD to "netting sets" does not apply to netting in the case of other non-DCs. Further, Article 4 of the CDRVD does not take into account cross-product netting agreements involving non-DC products. Counterparties to such non-DCs the subject of cross-product netting agreements will need to rely on the NCWO principle to ensure that such non-DC liabilities are treated on a net basis for bail-in purposes. This means that the IIRCP could experience a different result to that expected on a normal insolvency (where bail-in does not apply). It is also unclear how the NCWO principle would apply in this situation.
Valuations: the relationship between the BRRD Article 36 valuation, the BRRD Article 74 valuation and the valuation of DCs for write-down and conversion purposes set out in Article 49 of the BRRD is unclear. However, the CDRVD clarifies that the BRRD Article 49 valuation is to be treated as part of the BRRD Article 36 valuation with the aim of determining a prompt valuation for bail-in purposes.62
Valuation of replacement trades: pursuant to the CDRVD, if the IIRCP is able to provide evidence of commercially reasonable replacement trades, the valuer must determine the close-out amounts using those prices.63 This methodology seems similar to the Market Quotation valuation measure under the 1992 ISDA Master Agreement in that it is based on market prices, except that the CDRVD uses executed trades, not just quotations, and there is no express requirement to use reference market-makers. The valuation simply has to be "commercially reasonable".64 Whilst the valuer is entitled to specify the criteria which will apply in determining whether replacement trades are "commercially reasonable", there is no clear guidance as to what evidence is suitable for this purpose or as to the contents of any summary.65
Commercially reasonable replacement trades: it is unclear how the requirement to use a "commercially reasonable replacement trade" works under the CDRVD for bespoke transactions (if no common market practice exists) or how the requirement to make "reasonable efforts to obtain best value for money" should be interpreted (balancing factors such as speed and certainty of execution against price). Will the IIRCP have to consider alternative methods of execution (such as replacing transactions on a portfolio basis rather than individually)? Does the obligation to "mak[e] reasonable efforts in order to obtain best value for money" impose on the IIRCP a new (or higher) legal standard than that applicable under the DC in question? By way of comparison, the 2002 ISDA Master Agreement requires the use of "commercially reasonable procedures in order to produce a commercially reasonable result".
Fallback valuation: the use of the specified valuation inputs in the fallback valuation methodology set out in Article 6(2) of the CDRVD means that such valuation method is more similar to the calculation of a "Close-out Amount" under the 2002 ISDA Master Agreement than to the "Market Quotation" mechanism under the 1992 ISDA Master Agreement. However, costs of funding are not expressly included. If the IIRCP is not able to provide commercially reasonable replacement trades within the set period, the valuer is permitted to take into account a wide range of valuation data. Where a fallback valuation is to be performed, the IIRCP will only have limited control over the valuation method and process. Note that in order to provide certainty to the RA in relation to the BRRD Article 74 valuation, the BRRD does not provide for any automatic right of appeal for a creditor. However, as the NCWO principle is fundamental to the BRRD, Article 74 of the BRRD provides for a second independent valuation to be performed as soon as possible after the bail-in occurred.
Payments to maturity: the RA is required to take into account the close-out methodology set out in the relevant netting agreement. There is an obvious tension between such a requirement and the fallback valuation methodology set out in Article 6 of the CDRVD. Further, the close-out methodology in the relevant netting agreement will vary (under current English law) depending on whether the parties have contracted on the basis of the 1992 ISDA Master Agreement and the 2002 ISDA Master Agreement. Valuations under the 1992 ISDA Master Agreement and/or the 2002 ISDA Master Agreement may be different (and potentially significantly different) from valuations under the CDRVD and/or the BRRD. It is also unclear how this fits with the NCWO principle.
Clean versus dirty valuations: under current English law, there is a divergence of judicial opinion as to where one values clean i.e. assuming all payment obligations are performed to transaction maturity (in relation to the 1992 ISDA Master Agreement) or dirty i.e. taking into account provisions that may result in transaction termination prior to maturity (in relation to the 2002 ISDA Master Agreement). Article 5(1) of the CDRVD expressly requires that the close-out amount reflects the costs that the IIRCP would incur to replace the economic equivalent of the terminated DCs including "the option rights of the parties in respect of those contracts". This suggests that valuations will be "dirty" (as per the 2002 ISDA Master Agreement). Accordingly, if the DC in question is a 1992 ISDA Master Agreement, there could be a difference (and potentially a significant difference) between the expected close-out amount under the 1992 ISDA Master Agreement and the close-out amount calculated for the purpose of Article 49 of the BRRD. It is also unclear how this fits with the NCWO principle.
IIRCP creditworthiness: a IIRCP's creditworthiness may be taken into account in the 2002 ISDA Master Agreement. No equivalent provision is included in the CDRVD. If actual commercially reasonable replacement trade prices are obtained, this difference is of no consequence. However, if the fallback valuation methodology applies, there is no provision to adjust theoretical prices for counterparty credit. This creates a potential discrepancy between the 2002 ISDA close-out amount valuation and the BRRD Article 49 valuation. It is also unclear how this fits with the NCWO principle.
Unpaid amounts: unpaid amounts are taken into account in the termination amount.66 The only guidance in the CDRVD as to how unpaid amounts are valued is the reference to "fair market value" where the unpaid amount represents the value of an undelivered asset where settlement is to be by delivery.67
Collateral: collateral is included in the determination of the termination amount if "due". The use of such a term is unfortunate as collateral may not be not technically due under the terms of the relevant DC.68
Equally ranked liabilities: for the purposes of determining the expected losses (as part of the numerator of the Article 36 valuation), Article 3(1)(a)(i) of the CDRVD requires that the portion of PBIDLs within all "equally-ranked" liabilities be determined. It is slightly unclear as to what are "equally ranked" liabilities for such purpose. Presumably, as a result of the application of Article 48 of the BRRD, equally ranked liabilities are all unsecured liabilities which are not Tier 2 or additional Tier 1 capital instruments or subordinated debt.
Cleared derivatives: the CDRVD specifies the valuation methodology (in the case of cleared derivatives) in the case of the DC between the clearing member (IIR) and the CCP. In simple terms, the valuation methodology used by the CCP will apply, other than in limited circumstances.69 The CDRVD does not mandate a specified valuation methodology in relation to the DC between the clearing member and the end client. In the case of the end client DC, the general valuation methodology of the CDRVD will apply. This raises the possibility that the valuation of the end client CD and the clearing house DC could be different (and potentially significantly different). The end client's protection in this case, other than the NCWO principle, is to port the defaulted transaction (in accordance with the relevant CCP's rules) to a back-up clearing member.
Timing of valuation: Article 8(1) of the CDRVD specifies the time at which the valuer must determine the value of the PBIDLs. Further provisional valuations are permitted which may then be updated in the definitive valuation under Article 36. The RA may also adjust the treatment of creditors on bail-in, or provide compensation on the basis of the BRRD Article 74 valuation. This raises the possibility of timing differences between valuations under the CDRVD and/or the BRRD and under the relevant DC. Any difference in timing may result in a difference (and potentially a significant difference) between the expected valuation under the DC and the valuation determined for the purposes of bail-in. The CDRVD also mandates the use of end of day prices in certain instances (see Article 6(2)(a) and 6(5) of the CDRVD) and the use of mid-market prices in certain instances (see Article 6(2)(a) and 6(2)(b) of the CDRVD). There are no equivalent provisions in the 1992 ISDA Master Agreement and/or the 2002 ISDA Master Agreement.70
As mentioned above, the application of the bail-in tool to DCs will have no impact on Collateralised PBIDLs (to the extent that the value of the PBIDLs does not exceed the value of the related security/collateral/margin). Further, as PBIDLs may be complex and difficult to value, it may be the case that RAs are less inclined to bail-in PBIDLs (to avoid valuation disputes, the risk of litigation and breaching the NCWO principle) or more inclined to exempt PBIDLs from bail-in under Article 44(3) of the BRRD (subject to the exceptional circumstances limitation).
However, in relation to in-scope DCs, the valuation methodology under the CDRVD (subject to the NCWO principle) raises several valuation issues for IIRCPs; particularly for non-standard DCs or in abnormal market conditions where "commercially reasonable replacement trades" cannot be obtained.
25 There are general exclusions from the scope of bail-in under Article 44(2) of the BRRD (including but not limited to secured liabilities (to the extent that the value of the liability does not exceed the value of the collateral), client money, covered deposits and liabilities of less than 7 days owing to payment and settlement systems).
26 European Market Infrastructure Regulation (EU) No. 648/2012.
27 Article 3(1) and (3) of CDRVD.
28 Article 3(3) of the CDRVD.
29 Article 3(5) of the CDRVD.
30 Article 3(4) of the CDRVD.
31 Article 6(1) of the CDRVD.
32 Article 1(6) and (7) of the CDRVD.
33 Article 6(2) of the CDRVD
34 Regulation (EU) 575/2013.
35 Article 6(4) of the CDRVD.
36 Article 6(4)(a) of the CDRVD.
37 Article 5(1) of the CDRVD.
38 Article 1(1) of the CDRVD.
39 Article 2(1) of the CDRVD.
40 Article 2(1)(a) of the CDRVD.
41 Article 2(1)(b) of the CDRVD.
42 Article 2(1)(b)(i) of the CDRVD.
43 Article 2(1)(b)(ii) of the CDRVD.
44 Article 2(1)(b)(iii) of the CDRVD.
45 Article 2(1)(b)iv) of the CDRVD.
46 Article 2(2) of the CDRVD.
47 Articles 3(6) and 6(6) of the CDRVD (except in the limited circumstances specified in Article 7(7) of the CDRVD).
48 Article 7(1) of the CDRVD.
49 Article 7(2) of the CDRVD.
50 Article 7(6) of the CDRVD.
51 Article 6(6) of the CDRVD.
52 Article 6(5) and 8(3) of the CDRVD.
53 Article 8(1) of the CDRVD.
54 Article 8(1)(a) of the CDRVD.
55 Article 8(1)(b) of the CDRVD.
56 Article 8(1)(c) of the CDRVD.
57 Article 8(2) of the CDRVD.
58 Article 8(3) of the CDRVD.
59 Article 8(4) of the CDRVD.
60 Article 8(4) of the CDRVD.
61 See Articles 36 and 74 of the BRRD.
62 See also Recital (22) of the CDRVD.
63 Article 6(1) of the CDRVD.
64 See the definition of "replacement trade" in Article 1(6) of the CDRVD.
65 See Article 3(3) of the CDRVD.
66 Article 5(1) of the CDRVD.
67 Article 5(2)(b) of the CDRVD.
68 Article 5(1)(a) of the CDRVD.
69 Article 3(6), 6(6) and 7(7) of the CDRVD.
70 In the 2002 ISDA Master Agreement, mid-market valuations are used in the case of a termination due to Illegality or a Force Majeure Event.
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