Prudential Regulation Authority Rulebook

1.

For the purposes of this Article, ‘written credit derivative’ means any financial instrument through which an institution effectively provides credit protection including credit default swaps, total return swaps and options where the institution has the obligation to provide credit protection under conditions specified in the options contract.

2.

In addition to the calculation laid down in Article 429c of this Chapter, institutions shall include in the calculation of the exposure value of written credit derivatives the effective notional amounts referenced in the written credit derivatives reduced by any negative fair value changes that have been incorporated in tier 1 capital (leverage) with respect to those written credit derivatives.

Institutions shall calculate the effective notional amount of written credit derivatives by adjusting the notional amount of those derivatives to reflect the true exposure of the contracts that are leveraged or otherwise enhanced by the structure of the transaction.

3.

Institutions may fully or partly reduce the exposure value calculated in accordance with paragraph 2 by the effective notional amount of purchased credit derivatives, provided that all the following conditions are met:

1. (a) the remaining maturity of the purchased credit derivative is equal to or greater than the remaining maturity of the written credit derivative;
2. (b) the purchased credit derivative is otherwise subject to the same or more conservative material terms as those in the corresponding written credit derivative;
3. (c) the purchased credit derivative is not purchased from a counterparty that would expose the institution to Specific Wrong-Way risk, as defined in point (b) of Article 291(1) of the CRR;
4. (d) where the effective notional amount of the written credit derivative is reduced by any negative change in fair value incorporated in the institution's tier 1 capital (leverage), the effective notional amount of the purchased credit derivative is reduced by any positive fair value change that has been incorporated in tier 1 capital (leverage);
5. (e) the purchased credit derivative is not included in a transaction that has been cleared by the institution on behalf of a client or that has been cleared by the institution in its role as a higher-level client in a multi-level client structure and for which the effective notional amount referenced by the corresponding written credit derivative is excluded from the total exposure measure in accordance with point (g) or (h) of the first subparagraph of Article 429a(1) of this Chapter, as applicable.

For the purpose of calculating the potential future exposure in accordance with Article 429c(1), institutions may exclude from the netting set the portion of a written credit derivative which is not offset in accordance with the first subparagraph of this paragraph and for which the effective notional amount is included in the total exposure measure.

4.

For the purposes of point (b) of paragraph 3:

1. (a) if an institution provides written protection via some type of credit derivative, the institution may only recognise offsetting from another purchased credit derivative to the extent that the purchased protection is certain to deliver a payment in all potential future states;
2. (b) ‘material term’ means any characteristic of the credit derivative that is relevant to the valuation thereof, including the level of subordination, the optionality, the credit events, the underlying reference entity or pool of entities, and the underlying reference obligation or pool of obligations, with the exception of the notional amount and the residual maturity of the credit derivative; and
3. (c) two reference names shall be the same only where they refer to the same legal entity.

5.

By way of derogation from point (b) of paragraph 3, institutions may use purchased credit derivatives on a pool of reference names to offset written credit derivatives on individual reference names within that pool where the pool of reference entities and the level of subordination in both transactions are the same.

6.

Institutions shall not reduce the effective notional amount of written credit derivatives where they buy credit protection through a total return swap and record the net payments received as net income, but do not record any offsetting deterioration in the value of the written credit derivative in tier 1 capital (leverage).

7.

In the case of purchased credit derivatives on a pool of reference obligations:

1. (a) institutions may reduce the effective notional amount of written credit derivatives on individual reference obligations by the effective notional amount of purchased credit derivatives in accordance with paragraph 3 only where the protection purchased is economically equivalent to buying protection separately on each of the individual obligations in the pool;
2. (b) if an institution purchases credit protection on a pool of reference names through credit derivatives, but the credit protection purchased does not cover the entire pool, then the written credit derivatives on the individual reference names may not be offset;
3. (c) by way of derogation from (a) and (b), purchased credit protection may offset written credit derivatives on a pool where the credit protection purchased through credit derivatives covers the entirety of the subset of the pool on which the credit protection has been sold.

[Note: This rule corresponds to paragraphs (5) to (7) of Article 429a of the CRR as it applied immediately before revocation by the Treasury.]