Legal development

BRRD: valuation of derivatives and contractual stays in financial contracts

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    This briefing looks at two consultations relating to the Bank Recovery and Resolution Directive (the BRRD) that are currently open and due to close shortly. The first deals with the method for valuing derivative contracts on a "bail-in". The second proposes a new rule requiring contractual recognition of a stay on enforcement of termination and close-out netting rights in financial contracts during a resolution process under the BRRD. Both consultations will have a significant impact on the treatment of derivative transactions with a bank or investment firm which becomes subject to resolution measures.

    Valuation of derivatives

    On 13 May 2015, the European Banking Authority (the EBA) published a Consultation Paper on the valuation of derivatives for the purposes of bail-in under the BRRD. The Consultation Paper attaches draft Regulatory Technical Standards (RTS).


    • Under the bail-in tool in the BRRD, resolution authorities have the power to write down or convert into equity certain liabilities of an institution in resolution with the aim of ensuring that shareholders and creditors bear an appropriate share of the losses arising from the failure of the institution.
    • Derivatives liabilities are within the scope of the bail-in tool, although the relevant resolution authority can specifically exclude them from the application of the tool in exceptional circumstances.
    • Liabilities cannot be written down or converted under the bail-in tool to the extent that they are collateralised or secured.
    • The power to bail in derivatives liabilities applies only upon or after close-out of the derivative contract.
    • Resolution authorities are empowered to terminate and close out derivative contracts in order to apply bail-in.


    In comparison with other types of liabilities that may be subject to bail-in, derivative transactions, which may be complex and bespoke, present particular challenges in respect of valuation for the bail-in tool. Accordingly, the BRRD mandates the EBA to produce draft RTS specifying three elements of the valuation:

    • the methodology for determining the value of liabilities under derivative contracts;
    • the principles for establishing the point in time at which such value should be established; and
    • the methodology for comparing the destruction of value as a result of the close-out of derivatives with the amount of losses borne by those derivatives in a bail-in.

    There is a power for the relevant resolution authority to exclude derivatives from the bail-in if the write-down of such contracts would cause a destruction of value greater than the value of losses borne by closing out such contracts, but the resolution authority must make this determination before exercising the power to close out.

    Purposes of valuation

    The valuation of derivatives is relevant to two stages of the resolution process under the BRRD.

    Before using the bail-in tool, the relevant resolution authority must ensure that a fair, prudent and realistic valuation of all the assets and liabilities of the institution in resolution is carried out pursuant to Article 36. This valuation is to be used to determine whether the conditions for resolution are satisfied and, if so, the appropriate resolution action to be taken. Where the action is bail-in, the valuation can also be used to inform the resolution authority's decision as to the extent of the write-down or conversion.

    Once it has decided to use the bail-in tool, the resolution authority must follow rules set out in Article 49 in valuing derivatives to determine the extent of the write-down or conversion.

    These two provisions are somewhat ambiguous about the method of valuation of derivatives for bail-in purposes.

    On the one hand, in relation to the first stage the BRRD provides:

    "Where derivative transactions are subject to a netting agreement, the resolution authority or an independent valuer shall determine as part of the valuation under Article 36 the liability arising from those transactions on a net basis in accordance with the terms of the agreement."

    On the other, Article 49(4) provides:

    "Resolution authorities shall determine the value of liabilities arising from derivatives in accordance with… appropriate methodologies for determining the value of classes of derivatives, including transactions that are subject to netting agreements."

    The first excerpt suggests that the terms of the relevant agreement will govern any close-out valuation at the first stage, whereas the second suggests that the resolution authority may use extraneous methodologies in valuing derivatives for bail-in purposes. Therefore, the basis of valuation may not be entirely clear in the primary text.

    The Consultation Paper appears to acknowledge this ambiguity by noting that Articles 36 and 49 should be read together and operate together to provide a valuation process that can be used swiftly, as is necessary in a resolution scenario. The recitals to the draft RTS note the need for consistent interpretation of the two provisions cited above.

    Determination of value

    The resolution authority has the power to close out a derivative contract on notice, taking effect immediately or at a later date and time specified in the notice. The draft RTS emphasise the need to be able to value derivative transactions within a short time after close-out and in an objective manner in order to avoid the types of delays and disputes that occurred in the insolvencies of institutions that failed during the financial crisis precipitated by the demise of Lehman Brothers in 2008. There is no further guidance as to the period of time which can be specified for the close out: this may be problematic for counterparties to relatively illiquid trades if the time specified comes too soon after the date of the notice.

    The determination of the value of each derivative transaction for the purposes of the close-out is made by the resolution authority or an independent valuer, not the non-defaulting party as would be the case under most market standard derivatives master agreements. Such determination can be based on "commercially reasonable replacement trades", which term is defined as "a replacement trade entered into on a netted risk exposure basis, on terms consistent with common market practice and making best efforts in order to obtain best value for money". The EBA has confirmed that this is intended to mean executed trades and not just quotations of executable prices.

    Best efforts to obtain value for money might entail executing transactions in a form different from that of the closed-out transaction (for example, by replacing transactions on a portfolio basis rather than individually), but this is not made expressly clear in the draft RTS. It is somewhat unclear, however, whether the concept of "making best efforts in order to obtain best value for money" is intended to impose on the counterparty a higher legal standard than would otherwise apply on a contractual basis. For example, this differs from the standard of using "commercially reasonable procedures in order to produce a commercially reasonable result" that applies under the 2002 ISDA Master Agreement.

    The counterparty can provide evidence of commercially reasonable replacement trades by a date and time specified by the resolution authority. Under the draft RTS, such date can be the close-out date or, if that would not be commercially reasonable, a day on which a price is available in the market for the underlying asset.

    If the counterparty provides evidence of any actual commercially reasonable replacement trades by the deadline set, then the valuer is required to determine the close-out amount based on such trades.

    Where the counterparty does not provide such evidence by the deadline, where the valuer concludes that the relevant trades were not on commercially reasonable terms or where the valuer decides to use a provisional valuation from the first stage of the process, the valuer must determine the close-out amount based on:

    (a) mid-market end-of-day prices in line with the institution's own processes;

    (b) mid-to-bid or mid-to-offer spread, depending on direction of the position, to estimate the loss or cost deemed incurred in liquidating, obtaining or re-establishing any hedge or related trading position; and

    (c) adjustments to (b) to reflect the size of the exposure and creditworthiness of the counterparty.

    Notwithstanding that the above method appears to be prescriptive, the draft RTS state that the valuer may also rely on:

    • valuations generated by its own systems for standardised products;
    • internal models and valuations by the institution in resolution;
    • data from counterparties; and
    • market data, quotes from market makers or values obtained from CCPs.

    It is not entirely clear how the use of these sources would be combined with the above method.

    There appears to be no obligation on the valuer to take into account valuation data provided by the counterparty, other than commercially reasonable replacement trades, as described above. In practice, counterparties may not be able to or may not wish to enter into replacement trades within the period set by the resolution authority, in particular where the original trade is highly structured and/or relatively illiquid.

    Close-out netting

    The draft RTS confirm that the resolution authority must respect "netting sets", therefore no cherry-picking of contracts is permitted. Where the derivative contracts are subject to a netting agreement, the valuer must determine a single amount, either owing by or owing to the institution in resolution, for all derivative contracts in the relevant netting set.

    The amount to be determined is the sum of:

    (a) all unpaid amounts, collateral or other amounts due to the counterparty, less all unpaid amounts, collateral or other amounts due from the counterparty; and

    (b) a close-out amount covering the amount of losses or costs incurred by the counterparty, or gains realised by it, in replacing or obtaining the economic equivalent of the material terms of the contracts and the option rights of the parties in respect of the terminated contracts.

    This methodology is broadly similar to the concept of "Close-out Amount" under the 2002 ISDA Master Agreement, although there are some key differences:

    • there is no explicit requirement that, in valuing a derivative contract, it should be assumed that all conditions precedent to the performance of the parties' obligations will be satisfied, therefore it appears possible to make a determination on either a "clean" or "dirty" basis;
    • there appears to be no overriding duty to use commercially reasonable procedures in order to achieve a commercially reasonable result; and
    • costs of funding are not expressly included.

    However, there is some protection in the BRRD under the "no creditor worse off" principle. This requires that where the bail-in tool has been applied, creditors whose claims have been written down do not incur losses greater than they would have incurred on a winding-up of the institution.

    Cleared derivatives

    The draft RTS specify that the general valuation methodology described above does not apply to centrally cleared derivatives to which the institution in resolution is party as a clearing member facing the CCP.

    In the case of such cleared transactions, the valuation is made on the basis of valuations provided by the relevant CCP in accordance with its procedures within an agreed deadline.

    The resolution authority can substitute its own valuation where:

    • the CCP does not meet the deadline; or
    • the CCP valuation is not in line with the CCP's own procedures.

    The draft RTS do not, however, specify that the methodology described in this section should be used for the client leg of a cleared transaction, being a transaction between a clearing member and its client. It appears that the client leg would be valued using the general methodology described above, therefore the valuation could be different from that of the cleared leg with the CCP, which would be inconsistent with the concept of client clearing whereby the economic effects of the cleared transaction should be passed through to the client.

    Time for valuation

    The draft RTS provide that the valuation of derivative contracts is as at:

    • the day and time of the replacement trades (where applicable);
    • the day and time of the CCP determination (where applicable in relation to cleared trades); and
    • the close-out date, or if not commercially reasonable, the day and time at which a price is available in the market.

    A provisional valuation can be made on the basis of estimates; for example, to determine whether the conditions for taking resolution measures have been met. Such provisional valuations can be updated to reflect the market conditions at the time referred to above.

    Comparing destruction in value against bail-in potential.

    Before closing out a derivative contract, the resolution authority is required to compare:

    (a) the amount of losses that would be borne by the derivative contracts in a bail-in, against

    (b) the costs and expenses, or other impairment in value incurred as a result of the close-out, being the sum of the following:

    • re-hedging costs incurred by the counterparty, which might increase its claim;
    • the expected costs of the institution to be incurred in re-hedging any open exposures;
    • any reduction in franchise value of the institution in resolution, including valuation impairments, and any impact on funding costs or income levels; and
    • any precautionary buffer against adverse implications, such as errors and disputes.

    The resolution authority may exclude derivative contracts from being closed out and written down under the bail-in tool if the application of the bail-in tool to such liabilities would cause a destruction in value such that the losses borne by other creditors would be higher than if those liabilities had been excluded from the bail-in.


    The interaction of the bail-in tool with other elements of regulatory reform, particularly impending rules under EMIR, will have a significant effect on the extent to which the tool is used. Under EMIR, rules on the margining of non-cleared derivatives are currently being developed. (See our recent briefing: "ESAs publish draft margin requirements for non-cleared OTC derivatives".) Once those rules are implemented, the proportion of non-cleared trades that are collateralised is likely to increase. Also, mandatory clearing is being implemented. CCPs authorised or recognised under EMIR require their clearing members to post collateral in support of their obligations under cleared trades. Since both of these developments require transactions to be collateralised and, as mentioned in the "Background" section above, liabilities will not be written down or converted under the bail-in tool to the extent that they are collateralised or secured, the proportion of an institution's derivative transactions that are affected by bail-in may be relatively slight. Nonetheless, the valuation methodology under the RTS will be critical to ensure that the in-scope trades receive appropriate treatment on a bail-in.

    Next steps

    The consultation is open until 13 August 2015. The EBA said in a public hearing that they would aim to produce the final draft RTS by the end of October 2015. The BRRD requires member states to implement the bail-in tool by 1 January 2016, although the UK has implemented it early, from January 2015 (except the minimum requirement for eligible liabilities).

    Contractual stays in financial contracts governed by third country law

    The Bank of England and the Prudential Regulation Authority (the PRA) have published a consultation paper proposing a new rule for the PRA Rulebook requiring the contractual adoption of UK resolution stays in certain financial contracts governed by third-country law, that is, the law of a jurisdiction outside the European Economic Area (the EEA).

    The BRRD contains a power for resolution authorities to impose a stay on enforcement of rights of termination and close-out in financial contracts where an institution is subject to resolution measures. This is to enable an orderly valuation and resolution of the institution's liabilities without increasing the risk of financial contagion. The effect of this stay should be recognised in EEA countries which implement the BRRD. However, where the relevant financial contract is governed by the law of a non-EEA state, there is a risk that the stay would not be recognised under such law. Accordingly, the new rule seeks to achieve the same outcome by requiring UK banks and investment firms covered by the BRRD to amend their financial contracts to include an equivalent restriction.

    The contractual stay requirement

    The proposed rule would apply to PRA-authorised UK banks, building societies and PRA-designated UK investment firms as well as their qualifying parent undertakings ("firms") in respect of specified financial contracts governed by the law of a non-EEA jurisdiction. It would prohibit firms from creating new obligations or materially amending an existing obligation under such a financial contract, unless the counterparty has agreed in writing to be subject to similar restrictions on termination, acceleration, close-out, set-off and netting, as would apply as a result of the firm's entry into resolution (or the write-down or conversion of the firm's regulatory capital at the point of non-viability) if the contract were governed by the laws of the United Kingdom (and, where the relevant firm is not a credit institution or investment firm, as if it were one).

    For example, a firm would not be permitted to enter into new trades with a counterparty without ensuring that an amendment had been made to the relevant contract to incorporate a provision giving effect to the BRRD stay to the same extent as if the law of the United Kingdom governed the contract. A material amendment to an existing trade would also be caught.

    Firms would also be obliged to ensure that, where their subsidiary credit institutions, investment firms and financial institutions trade in these products under third-country law, the subsidiaries also obtain agreement to the stay from their counterparties. Affected subsidiaries would include banks, brokers, asset managers and other providers of related financial services as well as intermediate holding companies.

    The rule is based on the definition of "financial contract" in the BRRD, except that the rule would not apply to short-term inter-bank borrowing and would make clear that all derivatives and master currency agreements are in scope. As a result, the rule would apply to obligations created under:

    • securities contracts including: contracts for the purchase, sale or loan of a security or a group or index of securities; options on a security or a group or index of securities; and repo or reverse repo transactions on a security or group or index of securities;
    • commodities contracts including: contracts for the purchase, sale or loan of a commodity or a group or index of securities; options on a security or a group of index of securities; and repo or reverse repo transactions on a commodity or group or index of commodities;
    • futures and forward contracts, including contracts (other than a commodities contract) for the purchase, sale or transfer of a commodity or property of any other description, service, right or interest for a specified price at a future date;
    • swap agreements including: swaps and options relating to interest rates; foreign exchange agreements; currencies; equities/equity indexes; debt/debt indexes; commodities/commodity indexes; weather; emissions or inflation; total return, credit spread or credit swaps; or any similar agreement;
    • all other derivatives; and
    • master agreements for any of the above for contracts for the sale, purchase or delivery of a currency.

    Obligations under financial contracts entered into with designated payment and securities settlement systems, recognised central counterparties, central banks or central governments, however, would be excluded.

    Timing and transitional arrangements

    Subject to certain transitional arrangements, the rule would apply in respect of obligations created under relevant financial contracts on or after 1 January 2016.

    The rule would also apply to an obligation created prior to the applicable date of the rule if a material amendment were made to the substantive terms of such obligation on or after such date.

    The PRA proposes to stagger the effective date of the rule by counterparty type, as follows:

    • 1 January 2016: credit institutions and investment firms;
    • 1 July 2016: asset managers (and the funds they manage), insurers and other counterparties that act on an agency basis; and
    • 1 January 2017: all other counterparties.

    The consultation on this proposed rule is open until 26 August 2015.


    Currently the main mechanism to achieve cross-border recognition of resolution stays in relation to derivative transactions is the ISDA Resolution Stay Protocol (the Stay Protocol). At present, the Stay Protocol is limited in that certain large banks have adhered to it at the prompting of regulators, but very few other entities have adhered to it since adherence is voluntary for them. Although the adhering banks together constitute a predominant proportion of the non-cleared derivatives market, this limited adherence means that there is an asymmetry in the market: if one of those banks were to become subject to resolution action, the others would not be able to terminate derivative transactions as a result; other counterparties to the bank in resolution may not, however, be prevented from using the resolution action as a trigger to terminate transactions. The rule proposed by the PRA would effectively convert the present voluntary approach into a mandatory regime for a wider range of market participants.


    Authors: James Knight, Partner

    The information provided is not intended to be a comprehensive review of all developments in the law and practice, or to cover all aspects of those referred to.
    Readers should take legal advice before applying it to specific issues or transactions.


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