21.The basis for the framework’s treatment of derivative transactions is a modified version of Standardised Approach to Counterparty Credit Risk (SA-CCR) in Basel III. It captures both the exposure arising from the underlying of the derivative contract and the related counterparty credit risk. The exposure measure amount is generally equal to the sum of the replacement cost (the mark-to-market value of contracts with positive value) and an add-on representing the transaction’s potential future exposure, with that sum multiplied by a scaling factor of 1.4. Valid bilateral netting contracts can reduce the exposure amount, but collateral received generally cannot. There are specific rules governing the treatment of cash variation margin, clearing services and written credit derivatives.

22.If, under a bank’s operative accounting standards, there is no accounting measure of exposure for certain derivative instruments because they are held (completely) off balance sheet, the bank must use the sum of positive fair values of these derivatives as the replacement cost.

23.Netting across product categories such as derivatives and SFTs is not permitted in determining the leverage ratio exposure measure. However, where a bank has a cross-product netting agreement in place that meets the eligibility criteria; it may choose to perform netting separately in each product category provided that all other conditions for netting in this product category that are applicable to the leverage ratio framework are met.”

24.Variation margin may be netted against derivative exposures, but only where the margin is paid in cash. This is the appropriate treatment for the leverage calculation, since the cash margin payment is, for all intents and purposes, a settlement of a liability. It also has the advantage, as would not have otherwise been the case, of encouraging the good risk management practice of taking cash collateral against derivative exposures, and is consistent with broader regulatory objectives that promote the margining of OTC derivatives.

25.One of the criteria necessary in order to recognize cash variation margin received as a form of pre-settlement payment is that variation margin exchanged must be the full amount necessary to extinguish the mark-to-market exposure of the derivative. In situations where a margin dispute arises, the amount of non-disputed variation margin that has been exchanged can be recognized.

26.Where a bank provides clearing services as a “higher level client” within a multi-level client structure, the bank need not recognize in its leverage ratio exposure measure the resulting trade exposures to the ultimate clearing member (CM) or to an entity that provides higher-level services to the bank if it meets specific conditions.

27.Among these conditions is a requirement that offsetting transactions are identified by the QCCP as higher level client transactions and collateral to support them is held by the QCCP and/or the CM, as applicable, under arrangements that prevent any losses to the higher level client due to the joint default or insolvency of the CM and any of its other clients. To clarify, upon the insolvency of the clearing member, there must be no legal impediment (other than the need to obtain a court order to which the client is entitled) to the transfer of the collateral belonging to clients of a defaulting clearing member to the QCCP, to one or more other surviving clearing members or to the client or the client’s nominee.

28.Another required condition is that relevant laws, regulation, rules, contractual or administrative arrangements provide that the offsetting transactions with the defaulted or insolvent CM are highly likely to continue to be indirectly transacted through the QCCP, or by the QCCP, if the CM defaults or becomes insolvent. Assessing whether trades are highly likely to be ported should consider factors such as a clear precedent for transactions being ported at a QCCP, and industry intent for this practice to continue. The fact that QCCP documentation does not prohibit client trades from being ported is not sufficient to conclude that they are highly likely to be ported.

29.The effective notional amount referenced by a written credit derivative is to be included in the leverage ratio exposure measure. Note that this is added to the general exposure measure for derivatives because a written credit derivative exposes a bank both to counterparty credit risk and to credit risk from the underlying reference entity for the derivative.

30.The effective notional amount of a written credit derivative may be reduced by any negative change in fair value amount that has been incorporated into the calculation of Tier 1 capital with respect to the written credit derivative. For example, if a written credit derivative had a positive fair value of 20 on one date, but then declines by 30 to have a negative fair value of 10 on a subsequent reporting date, the effective notional amount of the credit derivative may be reduced by 10 – the effective notional amount may not be reduced by 30. However, if on the subsequent reporting date, the credit derivative has a positive fair value of five, the effective notional amount cannot be reduced at all. This treatment is consistent with the rationale that the effective notional amounts included in the exposure measure may be capped at the level of the maximum potential loss, which means that the maximum potential loss at the reporting date is the notional amount of the credit derivative minus any negative fair value that has already reduced Tier 1 capital.

31.The resulting exposure amount for a written credit derivative may be further reduced by the effective notional amount of a purchased credit derivative on the same reference name, provided that certain conditions are met. Among these conditions is a requirement that credit protection purchased through credit derivatives is otherwise subject to the same or more conservative terms as those in the corresponding written credit derivative. For example, the application of the same material terms would result in the following treatments:

•In the case of single name credit derivatives, the credit protection purchased through credit derivatives is on a reference obligation that ranks pari passu with, or is junior to, the underlying reference obligation of the written credit derivative. Credit protection purchased through credit derivatives that references a subordinated position may offset written credit derivatives on a more senior position of the same reference entity as long as a credit event on the senior reference asset would result in a credit event on the subordinated reference asset.

•For tranched products, the credit protection purchased through credit derivatives must be on a reference obligation with the same level of seniority.

32.Another required condition is that the credit protection purchased through credit derivatives is not purchased from a counterparty whose credit quality is highly correlated with the value of the reference obligation, which would generate wrong-way risk. Specifically, the credit quality of the counterparty must not be positively correlated with the value of the reference obligation (i.e. the credit quality of the counterparty falls when the value of the reference obligation falls and the value of the purchased credit derivative increases). This determination should reflect careful analysis of the actual risk; a legal connection does not need to exist between the counterparty and the underlying reference entity.

33.For the purposes of the leverage ratio, the term “written credit derivative” refers to a broad range of credit derivatives through which a bank effectively provides credit protection and is not limited solely to credit default swaps and total return swaps. For example, all options where the bank has the obligation to provide credit protection under certain conditions qualify as “written credit derivatives.” The effective notional amount of such options sold by the bank may be offset by the effective notional amount of options by which the bank has the right to purchase credit protection that fulfils the conditions stated in the Standards. For example, to have the same or more conservative material terms, the strike price of the underlying purchased credit protection would need to be equal to or lower than the strike price of the underlying sold credit protection.