BRRD valuations and bail-in – how are derivatives treated?

On 23 May 2016, the European Commission adopted regulatory technical standards on the valuation of derivatives for the purpose of bail-in (the “Derivative Valuation RTS“) pursuant to Article 49(4) of the Bank Recovery and Resolution Directive (“BRRD“).

The Derivative Valuation RTS will affect any counterparty transacting derivatives with a bank or firm within the scope of the BRRD bail-in tool, as they determine the way in which such derivatives will be valued for the purpose of a bail-in.

Since derivative transactions may be complex and bespoke, they may present particular challenges in respect of valuation for bail-in. Accordingly, Article 49(5) of the BRRD specifically mandates the European Banking Authority (the “EBA“) to produce the methodology for their valuation.

In summary

• A resolution authority can force the close-out of derivative contracts and appoint a thirdparty valuer to carry out the valuation.
• Derivatives counterparties to institutions in resolution will have limited control over the valuation process or the methodology used, although valuation of the close-out amount will still be made on a net basis.

Meanwhile, the EBA is yet to finalise its draft regulatory technical standards on valuations under Articles 36 and 74 of BRRD. These valuations are used to determine several points in relation to resolution action under BRRD, principally whether an institution is “failing or likely to fail”, which resolution action is appropriate for the institution and the level of any write-down of the institution’s liabilities and capital instruments. They also determine the level of any creditors’ compensation under the “no creditor worse off” principle (“NCWO“), which ensures a treatment following resolution at least equal to what creditors would have received had the institution been subject to a winding-up on insolvency.

This briefing looks at what these developments mean for the valuation of derivatives on close-out and bail-in where an institution is in resolution.

Background – Bail-in and the BRRD valuations

By way of background, under Article 63 of BRRD, resolution authorities have the power to write down or convert into equity eligible liabilities of an institution in resolution, including liabilities arising under derivative contracts to the extent that they are not collateralised or secured or otherwise excluded either by the terms of Article 44(2) or by the resolution authority under Article 44(3). Whilst the power to write down or convert derivative liabilities applies only on close-out of the contract, Article 63 gives resolution authorities the ability to terminate and close out any derivative contracts (whether collateralised or not) in order to apply the bail-in tool.

Excluded liabilities – Article 44

Article 44(3) of BRRD permits the resolution authority to exclude liabilities, including derivatives, from bail-in in exceptional circumstances and on a case-by-case basis. These circumstances include (a) where the application of bail-in to those liabilities would cause a destruction in value such that the losses borne by other creditors would be higher than if those liabilities were excluded from bailin and (b) where it is not possible to conduct a bail-in within a reasonable time. Article 44(11) provides that the Commission should adopt a delegated act specifying further the circumstances in which liabilities could be excluded from bail-in. The Commission adopted this delegated act on 4 February 2016. The delegated act states that the decision to exclude otherwise eligible liabilities from the operation of the bail-in tool should be used to the minimum extent necessary. The recitals to the delegated act state that whilst it may be difficult to bail in derivatives liabilities, the method for bail-in of derivatives is clearly set out in Article 49 of BRRD and although determination of a netted amount may not be possible within a short time, this is mitigated by the ability to use a provisional valuation under Article 49.

Ex ante valuation – Article 36

Under Article 36 of BRRD, the resolution authority must ensure that a fair, prudent and realistic “ex ante” valuation of all assets and liabilities of the institution in resolution (the “Article 36 valuation“), including those arising under derivative contracts, is carried out by a person independent of both the institution and the resolution authority (the “valuer“), in order to determine, among other things, (a) whether the conditions for resolution and exercise of the bail-in tool are met and (b) where the bail-in tool is applied, the extent of the write-down or conversion to equity of eligible liabilities. This valuation may, where urgency demands, be a provisional valuation (a “provisional valuation“), and a definitive valuation must be carried out under Article 36 as soon as reasonably practicable afterward. Where all the requirements of Article 36 are met, the Article 36 valuation is treated as the definitive valuation for resolution purposes.

Ex post valuation – Article 74

Under Article 74 of BRRD, a further “ex post” valuation (the “Article 74 valuation“) is required to be carried out as soon as possible after the resolution action has been taken, in order to assess whether shareholders and creditors would have received better treatment if the institution in resolution had entered normal insolvency proceedings and therefore might be entitled to compensation under NCWO.

Both Article 36 and Article 74 mandate the EBA to submit draft regulatory technical standards to the Commission on the methods for these valuations. Both sets of RTS were published by the EBA in draft in November 2014. The current version of the EBA’s work programme suggests that one or both of these RTS may be delayed pending further work by the Commission.

Valuation of derivatives for bail in – Article 49

Meanwhile, Article 49(4) of BRRD sets out separate requirements which apply to the valuation of derivatives. These include a mandate to the EBA to publish the RTS setting out:

• appropriate methodologies for determining the value of classes of derivatives, including transactions subject to netting agreements;
• principles for establishing the point in time at which the valuation of the derivative positions should take place; and
• appropriate methodologies for comparing the destruction of value that would arise from the close-out and bail-in of derivative positions with the amount of losses of the institution which would be absorbed by the derivative liabilities in the event they were to be bailed in.

Repo and stock lending

Note that neither Article 49 nor Article 4 of the Derivative Valuation RTS apply the same protection for netting in the case of other product types which rely on close-out netting under master agreements, e.g. repo and stock-lending. Whilst liabilities under repo and stocklending contracts are generally collateralised and would therefore be ineligible for bail-in to the extent of the collateral, they could be eligible for bail-in to the extent there is or would be a net amount payable by the institution in resolution, taking account of collateral. The absence of express protection for the closeout netting provisions in repo or stocklending master agreements in Article 49 means that greater reliance would need to be placed on the NCWO principle, in order to ensure that such obligations are treated on a net basis for “bail-in” purposes.

Ex ante and ex post valuations and Article 49 Valuation of Derivatives – how do they interact?

The relationship between the Article 36 and Article 74 valuations and the valuation of derivatives for write-down and conversion set out in Article 49 (the “Article 49 Valuation”) is not entirely clear in the text of BRRD. However, the EBA has clarified in the text accompanying the Derivative Valuation RTS that the Article 49 valuation is to be treated as part of the Article 36 valuation and should aim to determine a prompt valuation for bail-in purposes.

The Article 49 valuation can therefore be conducted as a provisional ex ante valuation, to inform the decision as to whether the institution should be put into resolution. Where a resolution authority decides to write down or convert derivatives based on such a provisional valuation, it must ensure that a definitive Article 36 valuation is carried out after resolution and that the treatment of creditors is adjusted accordingly (by finalising the distribution of equity in the institution in resolution after the definitive ex ante valuation is complete or by providing compensation for the difference in treatment of creditors from the treatment they would have received on insolvency once the ex post valuation is complete).

Under Article 8(2) of the Derivative Valuation RTS, where such a provisional valuation of derivatives is used, it must be made on the basis of estimates relying on the data available at the time. Thereafter it must be updated to take account of new data available before the point of close-out, and included in the definitive Article 36 valuation. In a public meeting on 2 July 2015 in relation to the first draft of the Derivative Valuation RTS, the EBA commented that it expected that resolution authorities would be likely to carry out Article 49 valuations as provisional valuations initially.

Method for determining close-out amounts for derivatives

Requirement for notification

The Derivative Valuation RTS provide that resolution authorities shall notify the counterparty of the termination and close-out of derivative contracts, which may take place immediately or at a date and time specified in the notice. The notice will also give the counterparty a set period in which to provide evidence of commercially reasonable replacement trades and may specify criteria by which the authority will assess whether any replacement trades are commercially reasonable. It is not clear whether that set period must end on the date specified for termination or, if termination is immediate, how long that period might be. This period may also be changed by the resolution authority by notifying the counterparty.

Replacement trades

If the counterparty provides evidence of commercially reasonable replacement trades, the valuer must determine the close-out amounts at the prices of those replacement trades. This may be regarded as a similar mechanism to the Market Quotation measure under the 1992 ISDA Master Agreement in that it is based on market prices, although under the Derivative Valuation RTS the prices must be for executed trades, not just quotations, and the requirement that the replacement trade is “commercially reasonable” replaces the specific requirements to use reference marketmakers set out in the 1992 ISDA Master Agreement.

Meaning of “commercially reasonable”

The term “commercially reasonable replacement trade” is defined in the Derivative Valuation RTS to mean a “replacement trade entered into on a netted risk basis, on terms consistent with common market practice and by making reasonable efforts to obtain best value for money”. It is not very clear how this phrase should be interpreted, in particular in cases where it may not be possible to identify a common market practice, such as for highly bespoke transactions, or where best value for money conflicts with other considerations such as speed or certainty of execution. 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 Derivative Valuation RTS. Furthermore it is unclear 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.

Fallback valuation method

If the counterparty does not provide evidence of such replacement trades in the period specified, or where the replacement trades are considered by the valuer not to be on commercially reasonable terms, the resolution authority may construct its final, non-provisional ex ante close-out valuation on the basis of a fallback method using:

• mid-market end-of-day prices in line with the business-as-usual processes of the institution in resolution at the point in time of valuation (see below);
• the mid-to-bid or mid-to-offer spread (the “relevant spread“), depending on the direction of the netted risk position, in order to take account of which side of the trade the counterparty would have; and
• adjustments to these prices and spreads where necessary to reflect the liquidity of the market for the underlying risks or instruments and the size of the exposure relative to market depth as well as possible model risk (the “market/model-related adjustments“).

Notwithstanding that the above method appears to be prescriptive, the Derivative Valuation RTS provide that the valuer shall consider “a full range of available and reliable data sources” including both “observable market data” and theoretical prices generated by valuation models. The following data sources are specified as included:

• data provided by third parties, such as observable market data or valuation parameters, data and quotes from market-makers or, where a contract is centrally cleared, values or estimates obtained from CCPs;
• for standardised products, valuations generated by the valuer’s own systems;
• data available within the institution under resolution, such as internal models and valuations including any independent price verifications performed pursuant to the prudent valuation requirements in the trading book under the Capital Requirements Regulation;
• data provided by counterparties other than evidence of replacement trades, including data on current or previous valuation disputes with regard to similar or related transactions and quotes; and
• any other relevant data.

It is not entirely clear how the use of these sources would be combined with the fallback method. It may be that the intention is that these sources can be used to determine the relevant spread and any market/model-related adjustments (as defined above) but not the end-of day price (since that is to be based on the processes of the institution in resolution). The use of these sources would mean that the valuation method would be more similar to the calculation of “Close-out Amount” under the 2002 ISDA Master Agreement than to the “Market Quotation” mechanism under the 1992 ISDA Master Agreement, although one notable difference is that costs of funding are not expressly included.

It appears that in the absence of commercially reasonable replacement trades, the valuer must take into account a full range of available and reliable data sources, including but not limited to valuation data provided by the counterparty. Absent actual replacement trades, the counterparty will therefore have only limited control over the valuation method and process. 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.

In its response to the feedback on the first draft of the Derivative Valuation RTS, the EBA stated its view that actual replacement trades, if concluded on commercially reasonable terms, are the most objective source for a valuation for resolution purposes but that it had nevertheless amended the draft Derivative Valuation RTS in order to include counterparties’ quotations among the data sources to be used.

Does the valuation assume payments would have been made to maturity?

Under Article 49(5) of BRRD, the resolution authority is required to take into account the method for close-out under the relevant master netting agreement. There may be a tension between this and the application of the method set out above. Furthermore, as the contractual close-out method differs according to whether the parties have contracted on the basis of the 1992 version or the 2002 version of the ISDA Master Agreement, the resulting valuation may be significantly different from that achieved outside a resolution context.

Differences between the 1992 and 2002 ISDA Master Agreement

In relation to the question of whether the valuation is to assume payments would have been made to maturity, there are two different principal approaches to valuation of close-out amounts in the derivatives market. Judicial authority on the 1992 ISDA Master Agreement supports valuation on a “clean” basis, i.e. on the assumption that all payment obligations under section 2(a)(i) of the agreement continue to be performed through to maturity of the transaction, ignoring provisions that might have the effect of terminating the transaction before maturity. Under the 2002 ISDA Master Agreement however, judicial authority supports a valuation without the assumption that all payments continue to be made, so that for example an option to terminate a contract on termination of a back-to-back contract would be taken into account in valuing the close-out amount.

Approach of the Derivative Valuation RTS: clean versus dirty

Article 5(2) of the Derivative Valuation RTS requires the close-out amount to reflect the cost the counterparty would incur to replace the economic equivalent of the terminated contract “including the option rights of the parties in respect of those contracts”. This would appear to indicate that the close-out amount calculated under Article 49 would take account of the effect of termination rights on the economics of the transaction. This reflects market practice under the 2002 version of the ISDA Master Agreement but may not reflect the “clean” valuation which is supported by the courts under the 1992 version. Thus, if the institution in resolution and the counterparty have entered a 1992 ISDA Master Agreement, there could be a discrepancy between the expected close-out amount on insolvency and the close-out amount calculated in an Article 49 valuation on resolution.

Creditworthiness of the counterparty

On the other hand, a requirement which had appeared in the May 2015 draft of the Derivative Valuation RTS to adjust prices and spreads to reflect the creditworthiness of the counterparty seeking to replace the trade has been removed. The creditworthiness of the counterparty seeking to replace the trade may be taken into account under the 2002 ISDA Master Agreement. Clearly the creditworthiness of the counterparty will affect the price at which replacement trades can be executed, but there seems to be no requirement in the Derivative Valuation RTS to adjust theoretical prices for creditworthiness in the absence of actual replacement trades. This creates a potential discrepancy between the Article 49 valuation under the Derivative Valuation RTS and the close-out amount which would be calculated under a 2002 ISDA Master Agreement in the event of an ordinary insolvency. It is not clear from the Derivative Valuation RTS how any such discrepancies would be resolved, particularly in the light of NCWO.

Termination amount and netting

The termination amount ultimately determined by the valuer will be the sum of the close-out amount calculated as discussed above for all transactions in the netting set, plus any unpaid amounts, collateral or other amounts due from the institution under resolution to its counterparty, less any such amounts due from the counterparty.

Unpaid amounts

There is no clear guidance on how these unpaid amounts are valued, other than a reference to “fair market value” where the unpaid amount represents the value of an undelivered asset where settlement was to be by delivery.

Collateral

Collateral is included in the valuation, although the language of Article 5(1) of the Derivative Valuation RTS suggests that such collateral must be “due” between the parties, which may not technically be the case under the terms of the relevant agreement.

Netting set

Article 4 of the Derivative Valuation RTS provides that the valuer must determine a single amount payable by the institution in resolution or by the counterparty as a result of the close-out of all derivative contracts in a netting set, as defined in the netting agreement, thus protecting netting arrangements on a bail-in of derivative contracts. In the commentary accompanying its final draft of the Derivative Valuation RTS in December 2015, the EBA acknowledged that the effect of this is that amounts bailed in under derivative contracts subject to netting may be relatively small yet takes the view that the possibility of bail-in of these amounts enhances market discipline and scrutiny of risk profile of institutions by shareholders and counterparties. The Derivative Valuation RTS do not contemplate that the netting set could include non-derivative transactions and therefore do not incorporate cross-product netting involving other transactions such as repo, stock-lending or margin loans. This may conflict with the parties’ contractual position, and the position which would otherwise apply on a normal insolvency.

Comparing destruction in value on close-out with loss-absorbency of the derivative

In order that resolution authorities have guidance on how to determine whether a bail-in of derivatives would be an efficient means to absorb losses of the institution in resolution, Article 49 of BRRD also requires the EBA to set out methodologies for comparing the destruction in value caused by closing out derivative contracts with the amount of losses that would be absorbed by those derivatives on bail-in. The Derivative Valuation RTS therefore require the determination of two values for comparison:

• the proportion of derivative liabilities not exempt from bail-in and valued as part of the Article 36 valuation, within all “equally-ranked” liabilities (the “derivative portion”), multiplied by the total losses expected to be borne by all equal ranked liabilities (including the derivative liabilities) stemming from the close-out; and
• the destruction in value expected to be incurred as a result of the close-out, as a sum of the following:
  • the risk of increased claims from counterparties to reflect re-hedging costs;
  • the expected cost to the institution in resolution 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);
  • valuation impairments to underlying assets linked to the derivatives being closed-out, impact on funding costs, income levels or other reduction to franchise value arising from the close-out of derivative contracts; and
  • any precautionary buffer against adverse effects of close-out such as cost of errors or disputes.

It is not entirely clear what is meant by “equally ranked” liabilities in the first value. We assume it refers to the sequence of write-down and conversion of eligible liabilities set out in Article 48 of BRRD, under which unsecured liabilities which are to be written down in accordance with the hierarchy of claims in normal insolvency proceedings. This means that, after subtracting preferred creditors (such as certain depositors protected under Article 108 of BRRD), the denominator of the derivative portion would be the amount of all unsecured liabilities which are not Tier 2 or additional Tier 1 capital instruments or subordinated debt.

Once these values are determined, they should be compared prior to any decision being taken to close out the derivatives, as part of the ex ante valuation and in accordance with the Article 36 RTS. If the amount of losses expected to be incurred from the close-out exceeds the share of liabilities which would be available for bail-in, the resolution authority can consider exempting the derivative contracts from bail-in under Article 44(3) of BRRD.

For example, assume the notional amount of derivative liabilities not exempt from bail-in is 5 million, the amount of equally ranking unsecured liabilities is 50 million, and the losses expected to be borne by those unsecured liabilities is 20 million. The derivative portion will be 10% of 20 million – i.e. 2 million. If closing out those derivative contracts would result in a destruction in value through reestablishing hedges, increased claims etc. of more than 2 million, the resolution authority can treat the derivatives as exempt from bail-in, and the losses which would have been borne by those derivatives would be borne by other equally-ranked liabilities.

Cleared derivatives

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

Under the European Market Infrastructure Regulation (“EMIR“), CCPs are required to apply sound risk management procedures on default of a clearing member. These procedures generally require the CCP to replace the trades it has with the defaulting member according to agreed default procedures, which may include an auction among the other clearing members and the offsetting of any collateral posted by the defaulting member against any cost incurred by the CCP. The collateral posted is designed to be sufficient to cover the defaulting member’s liability to the CCP, therefore bail-in of uncollateralised liabilities is unlikely to be required. The defaulting member’s contribution to the default fund of the CCP may also be applied to reduce the costs incurred by the CCP.

Where the derivative contract is between an institution in resolution as a clearing member and a CCP, the Derivative Valuation RTS draw on these existing procedures for close-out of cleared derivatives. The resolution authority will notify the CCP and the CCP’s competent authority of the decision to close out the derivative and will agree with them a deadline by which the CCP must provide the valuation of the early termination amount. If the CCP fails to do so by the deadline, or the valuation by the CCP is not in line with the CCP’s default procedures under EMIR, the resolution authority may determine that the methods described above for valuation of non-cleared derivatives will be used. Again, the valuation may be made on a provisional basis, and an ex-post adjustment can be made.

Note that any valuations here not based on the CCP’s default procedure are only for resolution purposes and will not affect the CCP’s contractual and rulebook obligations. The Derivative Valuation RTS do not 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. However, the recitals to the Derivative Valuation RTS anticipate that the client would be permitted to use porting as its primary remedy, whereby it would rely on the CCP’s procedures for the transfer of the affected assets and positions to a back-up clearing member.

Point in time for close-out and valuation

Article 8(1) of the RTS provides that the valuer must determine the value of derivative liabilities at the following point in time:

• Where the valuer determines the close-out amount (i) on the basis of replacement trades, pursuant to Article 6(1) (i.e. commercially reasonable replacement trades provided by the counterparty), the date and time of the replacement trades, or (ii) in accordance with CCP default procedures, the date and time the early termination amount is determined by the CCP;
• 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.

Where a provisional ex ante valuation is made, the determination of the close-out value can be made earlier, based on the observable market data available at the time (described above). The resolution authority can request the valuer to update this provisional valuation at any time to reflect market developments or replacement trades, and where this evidence is available by the time closeout takes effect, it will be included in the ex post definitive valuation under Article 36. Resolution authorities may then either adjust the treatment of creditors on bail-in, or provide compensation on the basis of the Article 74 valuation.

Similarly, if the valuer makes an early determination in respect of derivatives entered between a clearing member in resolution and a CCP, the valuer must take account of estimates of expected losses provided by the CCP, and update them if definitive termination values are provided by the CCP prior to the agreed deadline.

Comment

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 finalised (see our briefing). 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 under “Background: bail-in and BRRD valuations” above, liabilities will not be written down or converted into equity by bail-in 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. Moreover, it may be that resolution authorities seek to absorb losses to the extent necessary for resolution by writing down or converting the institution’s unsecured debt and/or capital instruments and not to use the bail-in tool in respect of derivative contracts, in order to avoid complex valuations and the accompanying risk of litigation or breach of the no-creditor-worse-off principle. Indeed, the Bank of England has been candid in saying that this would be its preference in a resolution scenario.

Nonetheless, the valuation methodology under the Derivative Valuation RTS will be critical to ensure that the in-scope trades receive appropriate treatment if the bail-in tool is applied in respect of derivative contracts. Timing and next steps The RTS are now subject to approval by Parliament and the Council. Once approved, they will come into force twenty days after publication in the Official Journal of the EU.