The Basel Committee has finalized a standardized, non-internal-model-based method for calculating counterparty credit risk exposures associated with OTC derivatives, exchange-traded derivatives, and long settlement transactions. This blog post provides a high-level overview of the new standardized approach (**SA-CCR**), which replaces both the Current Exposure Method (CEM) and the Standardised Method (SM) in the Basel capital framework. In addition, the IMM shortcut method will be eliminated from the Basel capital framework once the SA-CCR takes effect, which is scheduled for **January 1, 2017**. In the Basel Committee’s June 2013 proposal, SA-CCR was referred to as the non-internal model method (NIMM).

**Potential Implications for Basel III Leverage Ratio: ** In its January 2014 revisions to the Basel III leverage ratio, the Basel Committee stated that it will consider whether the replacement for the CEM (*i.e.*, the SA-CCR) should be used to calculate derivative exposures for purposes of the Basel III leverage ratio. Our visual memo of the Basel Committee’s January 2014 revisions to the Basel III leverage ratio is available here.

**Potential Implications for Large Exposures Framework / Dodd-Frank Single Counterparty Credit Limits: **In its March 2013 proposed large exposures framework, the Basel Committee stated that “[o]nce the successor to the CEM (and the standardised method) has been approved, this method should be adopted by all banks for measuring OTC derivative exposure values in [the] large exposures framework.” The Federal Reserve has stated that it will take into account the Basel Committee’s large exposures framework before finalizing Dodd-Frank single counterparty credit limits (SCCLs). Our overview of the Basel Committee’s proposed large exposures framework is available here.

**Basel Committee’s Objective in Developing the SA-CCR**

According to the Basel Committee, its objective in establishing the SA-CCR is to develop a risk sensitive methodology that:

- Appropriately differentiates between margined trades (where variation margin (VM) is exchanged) and unmargined trades;
- Provides more meaningful recognition of netting benefits than the CEM and SM;
- Addresses other known deficiencies of the CEM and the SM;
- The CEM had been criticized for several limitations, including the fact that its failure to differentiate between margined and unmargined transactions; its supervisory add-on factors did not sufficiently capture the level of volatilities as observed over recent stress periods; and its recognition of netting benefits was too simplistic and not reflective of economically meaningful relationships between derivatives positions.
- Although being more risk-sensitive than the CEM, the SM was also criticized for several weaknesses. Like the CEM, it did not differentiate between margined and unmargined transactions or sufficiently capture the level of volatilities observed over stress periods in the last five years. In addition, the definition of “hedging set” led to operational complexity resulting in an inability to implement the SM, or implementing it in inconsistent ways.

- Draws on prudential approaches already available in the Basel framework;
- Minimizes discretion used by national authorities and banks; and
- Is calibrated to reflect the level of volatilities observed over the recent stress period.

**Key Changes to June 2013 NIMM Proposal**

The Basel Committee has made a number of revisions to its June 2013 NIMM proposal. These changes include, among other things:

- Increased specificity regarding the application of the approach to complex instruments;
- Introduction of a supervisory measure of duration for interest rate and credit derivative exposures;
- Removal of the one-year trade maturity floor for unmargined trades and the addition of a formula to scale down the maturity factor for any such trades with remaining maturities less than one year;
- Inclusion of a supervisory option pricing formula to estimate the supervisory delta for options;
- A cap on the measured exposure for margined transactions to mitigate distortions arising from high threshold values in some margining agreements; and
- Adjustments to the calibration of the approach with respect to foreign exchange, credit and certain commodity derivatives.

**Overview of SA-CCR**

The SA-CCR retains the same general structure as the CEM, consisting of a replacement cost (RC) component and a potential future exposure (PFE) component (see formula below).

- EAD is calculated separately for each netting set. RC is calculated at the netting set level whereas PFE add-ons are calculated for each asset class within a given netting set and then aggregated. A netting set is a group of transactions with a single counterparty that are subject to a legally enforceable netting agreement.
- An alpha factor of 1.4 is applied to the sum of these components to arrive at the exposure amount or exposure at default (EAD).
- The EAD for each netting set is multiplied by the risk weight associated with the particular counterparty in accordance with either the Basel capital framework’s standardized approach or internal ratings-based (IRB) approach for credit risk to determine the risk-weighted asset (RWA) amount.

**EAD = 1.4 x (RC + PFE)**

**Distinguishing Between Margined and Unmargined Netting Sets**

- The RC and PFE components are calculated differently for margined and unmargined netting sets. The EAD for a margined netting set is capped at the EAD of the same netting set calculated on an unmargined basis.
**Unmargined Netting Sets:**For unmargined netting sets, RC captures the loss that would occur if a counterparty were to default and were closed out of its transactions immediately. PFE represents a potential conservative increase in exposure over a**1-year**time horizon from the present date.**Margined Netting Sets:**For margined netting sets, RC captures the loss that would occur if a counterparty were to default at the present or at a future time, assuming that the closeout and replacement of transactions occur instantaneously. However, there may be a period (**margin period of risk**) between the last exchange of collateral before default and replacement of the trades in the market. The PFE represents the potential change in value of the trades during this period.- In both cases, the haircut applicable to noncash collateral in the RC formulation represents the potential change in value of the collateral during the appropriate time period (one year for unmargined trades and the margin period of risk for margined trades).
- For margined transactions, the minimum margin period of risk is determined as follows:
- At least 10 business days for non-centrally-cleared derivative transactions subject to daily margin agreements
- 5 business days for centrally cleared derivative transactions subject to daily margin agreements that clearing members have with their clients
- 20 business days for netting sets consisting of 5,000 transactions that are not with a central counterparty
- Double the margin period of risk for netting sets with outstanding disputes

**Calculating RC**

The formula for calculating RC depending on whether the trades with a counterparty are subject to a margin agreement. Where a margin agreement exists, the formula would apply both to bilateral transactions and central clearing relationships.

**Formula for Unmargined Transactions:** For unmargined transactions (that is, where VM is **not** exchanged, but collateral other than VM may be present), RC is defined as the greater of: (1) the current market value of the derivative contracts less net haircut collateral held by the bank (if any), and (2) zero. Bilateral transactions with a one-way margining agreement in favor of the bank’s counterparty (that is, where a bank posts, but does not collect, collateral) must be treated as unmargined transactions.

**RC = max{V **–** C; 0}**

- V is the value of the derivative transactions in the netting set.
- C is the haircut value of net collateral held, which is calculated in accordance with the net independent collateral amount (NICA) methodology.
**ICA and NICA:**The SA-CCR framework introduces the term independent collateral amount (**ICA**). ICA represents (1) collateral (other than VM) posted by the counterparty that the bank may seize upon default of the counterparty, the amount of which does not change in response to the value of the transactions it secures and/or (2) the Independent Amount (IA) parameter as defined in standard industry documentation. ICA can change in response to factors such as the value of the collateral or a change in the number of transactions in the netting set. Since both a bank and its counterparty may be required to post ICA, it is necessary to introduce a companion term, net independent collateral amount (**NICA**), to describe the amount of collateral that a bank may use to offset its exposure on the default of the counterparty. NICA does not include collateral that a bank has posted to a segregated, bankruptcy remote account, which presumably would be returned upon the bankruptcy of the counterparty. In other words, NICA represents any collateral (segregated or unsegregated) posted*by the counterparty*less the unsegregated collateral posted*by the bank*.- As discussed below, the SA-CCR allows over-collateralisation and negative mark-to market value to reduce PFE, but this would not affect RC.

**Formula for Margined Transactions: **For margined transactions, RC is calculated as follows:

**RC = max{V – C; TH + MTA – NICA; 0}**

- V and C are defined as in the unmargined formula
- TH is the positive threshold before the counterparty must send the bank collateral
- MTA is the minimum transfer amount applicable to the counterparty
- TH + MTA – NICA represents the largest exposure that would not trigger a VM call

**Calculating PFE**

**PFE = multiplier x AddOn ^{ (aggregate)}**

- The PFE portion consists of a multiplier (which allows for the partial recognition of excess collateral and negative mark-to-market value) and an aggregate add-on, which is based on add-ons for each asset class (interest rate, foreign exchange, credit, equity and commodity).
- Diversification benefits across asset classes are not recognized. Instead, the respective add-ons for each asset class are simply aggregated.

- The method for calculating the add-ons for each asset class hinges on the key concept of a “hedging set.” A “hedging set” under the SA-CCR is a set of transactions within a single netting set with respect to which partial or full offsetting is recognized for the purpose of calculating the PFE add-on.
- The add-on will vary based on the number of hedging sets that are available within an asset class. These variations are necessary to account for basis risk and differences in correlations within asset classes.
- The “multiplier” has the effect of scaling down the aggregate add-on to recognize the presence of excess collateral or negative mark-to-market value of the transactions. The multiplier is floored at 5% of the PFE add-on.

**Overview of Methods for Calculating Asset Class Add-ons**

**Interest Rate Derivatives:**A hedging set consists of all derivatives that reference interest rates of the same currency such as USD, EUR, JPY. Hedging sets are further divided into maturity categories. Long and short positions in the same hedging set are permitted to fully offset each other within maturity categories. Partial offset is recognized across maturity categories. See the flowchart below for steps in calculating the interest rate add-on.**Foreign Exchange Derivatives:**A hedging set consists of derivatives that reference the same foreign exchange currency pair such as USD/JPY, EUR/JPY, or USD/EUR. Long and short positions in the same currency pair are permitted to perfectly offset, but no offset may be recognized across currency pairs.**Credit Derivatives and Equity Derivatives:**A single hedging set is employed for each asset class. Full offset is recognized for derivatives referencing the same entity (name or index), while partial offset is recognized between derivatives referencing different entities.**Commodity Derivatives:**Four hedging sets are employed for different classes of commodities (one for each of energy, metals, agricultural, and other commodities). Within the same hedging set, full offset is recognized between derivatives referencing the same commodity and partial offset is recognized between derivatives referencing different commodities. No offset is recognized between different hedging sets.**Basis Transactions and Volatility Transactions:**With respect to each asset class, basis transactions and volatility transactions form separate hedging sets in their respective asset classes.- A
**basis transaction**is a non-foreign-exchange transaction (*i.e.*, both legs are denominated in the same currency) in which the cash flows of both legs depend on different risk factors from the same asset class. Common examples of basis transactions include interest rate basis swaps (where payments based on two distinct floating interest rates are exchanged) and commodity spread trades (where payments based on prices of two related commodities are exchanged). All basis transactions of a netting set that belong to the same asset class and reference the same pair of risk factors form a single hedging set. For example, all three-month LIBOR versus six-month LIBOR swaps in a netting set form a single basis hedging set. - A
**volatility transaction**is one in which the reference asset depends on the volatility (historical or implied) of a risk factor. Common examples of volatility transactions include variance and volatility swaps and options on volatility indices. Volatility transactions form hedging sets according to the rules of their respective asset classes. For example, all equity volatility transactions form a single volatility hedging set.

- A

**Allocation of Derivative Transactions to One or More Asset Classes**

- The designation of a derivative transaction to an asset class is be made on the basis of its primary risk driver. Most derivative transactions have one primary risk driver, defined by its reference underlying. When this primary risk driver is clearly identifiable, the transaction will fall into one of the asset classes described above.
- For more complex trades that may have more than one risk driver (
*e.g.*, multi-asset or hybrid derivatives), banks must take sensitivities and volatility of the underlying into account for determining the primary risk driver. - Bank supervisors may also require more complex trades to be allocated to more than one asset class, resulting in the same position being included in multiple classes. In that case, for each asset class to which the position is allocated, banks must determine appropriately the sign and delta adjustment of the relevant risk driver.

**General Steps for Calculating Asset Class Add-on**

Although the add-on formulas are asset class-specific, they have a number of common features, which are summarized in the following general steps:

- An adjusted notional amount based on actual notional or price is calculated at the trade level. For interest rate and credit derivatives, this adjusted notional amount also incorporates a supervisory measure of duration.
- A maturity factor reflecting the time horizon appropriate for the type of transaction is calculated at the trade level and is applied to the adjusted notional. Two types of maturity factor are defined: one for margined transactions and another for unmargined transactions.
- A supervisory delta adjustment is made to this trade-level adjusted notional amount based on the position (long or short) and whether the trade is an option, CDO tranche or neither, resulting in an effective notional amount.
- For instruments that are not options or CDO tranches, the supervisory delta is +1 for for a trade that is long in the primary risk factor and -1 for a trade that is short in the primary risk factor. “Long in the primary risk factor” means that the market value of the instrument increases when the value of the primary risk factor increases. “Short in the primary risk factor” means that the market value of the instrument decreases when the value of the primary risk factor increases.

- A supervisory factor is applied to each effective notional amount to reflect volatility.
- The trades within each asset class are separated into hedging sets and an aggregation method is applied to aggregate all the trade-level inputs at the hedging set level and finally at the asset-class level. For credit, equity and commodity derivatives, this involves the application of a supervisory correlation parameter to capture important basis risks and diversification.
- For credit, equity and commodity derivatives, the supervisory correlation parameters are derived from a singlefactor model and specify the weight between systematic and idiosyncratic components. This weight determines the degree of offset between individual trades, recognising that imperfect hedges provide some, but not perfect, offset. Supervisory correlation parameters do not apply to interest rate and foreign exchange derivatives.

**Flowchart for Calculating the Interest Rate Add-on**

**Materials: **Basel Committee, *The Standardised Approach for Measuring Counterparty Credit Risk Exposures* (Mar. 2014) available here: http://www.bis.org/publ/bcbs279.pdf.