Derivatives and Trading Activities
DER 1. U.S. Resolution Strategy and Wind-Down Scenarios; Applicability
Q. What is the relationship between a firm's U.S. resolution strategy and the passive and active wind-down analyses required under Section IX of the 2018 Guidance?
A. Section IX of the 2018 Guidance provides that a foreign based covered company (a "covered FBO") should conduct, in the manner specified, a passive wind-down analysis and an active wind-down analysis for each surviving U.S. IHC subsidiary4 with derivatives positions. The passive wind-down analysis and active wind-down analysis are intended to provide a baseline view of the risk profile of the derivatives positions at the firm's surviving U.S. IHC subsidiaries and a reference point to compare those analyses to the same entities under the firm's U.S. resolution strategy. The two wind-down analyses under Section IX are standalone analyses, separate from the firm's U.S. resolution strategy; the results of such analyses are generally not required to be incorporated into the U.S. resolution strategy's financial forecasts. However, the firm's analyses supporting the passive and active wind-down should include alternative estimates of RLEN and RCEN for the relevant surviving entities (passive and active RLEN/RCEN) as well as a discussion of the factors driving differences between the passive and active RLEN/RCEN estimates and the RLEN and RCEN estimates for the same entities under the firm's U.S. resolution strategy (see Question 1 at "LIQ 4. RLEN and MOL" in the Liquidity section). In doing so, the wind-down analyses will help inform an assessment of the U.S. resolution strategy's flexibility and resiliency to unanticipated conditions.
A firm's U.S. resolution strategy may incorporate a scenario that adopts the constraints of one of the prescribed wind-down analyses or an alternative, third scenario. For example, a firm may choose a going concern scenario (e.g., U.S. trading entities reestablish investment grade rating and do not enter a wind-down) as its U.S. resolution strategy, so long as the firm's resolution plan adequately supports the execution of that scenario and includes the required alternative wind-down analyses. Likewise, a firm may choose to adopt a combination of wind-down and going concern scenarios as its U.S. resolution strategy. For example, the U.S. resolution strategy could be a stabilization scenario for the U.S. bank entity and an active wind-down scenario for the U.S. broker-dealer entities.
DER 2. Hedging and Inter-Affiliate transactions
Q. What types of risk-reducing bilateral OTC trades, if any, are allowable under the two prescribed wind-down analyses required under Section IX of the 2018 Guidance?
A. Under the Active Wind-Down analysis required in Section IX of the 2018 Guidance, a firm should assume that entities generally cannot access bilateral OTC derivatives markets and may only hedge positions with exchange-traded and centrally cleared instruments. A firm may engage in certain risk reducing trades such as:
- To effect the novation of the firm's side of a derivatives contract to a new counterparty, bilateral OTC trades with the acquiring counterparty
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Bilateral trades with inter-affiliate counterparties that meet the following conditions:
- Reduce the credit exposure of each participating counterparty; and
- Do not materially increase the market risk of any such counterparty on a standalone basis, after taking into account hedging with exchange-traded and centrally-cleared instruments.
The firm must demonstrate the risk-reducing nature of the trade on the basis of information that would be known to the firm at the time of the transaction.
Under the passive wind-down analysis, a firm should assume that entities cannot access bilateral OTC derivatives markets and may only hedge positions executed with exchange-traded and centrally cleared instruments. The firm should assume there are no risk-reducing, non-cleared bilateral OTC derivatives trades.
Q2. Are derivatives used to hedge risks outside of the trading book within the scope of this requirement, such as for MSRs, structural interest rates, or debt instruments?
A2. The passive wind-down analysis and the active wind-down analysis required in Section IX of the 2018 Guidance are focused on the wind-down of the derivatives positions of a firm's U.S. IHC subsidiaries (trading and hedging positions; regardless of whether they are in the banking book or trading book). Derivatives outside of the trading book of a surviving U.S. IHC subsidiary are within the scope of those analyses. Note, in the active wind-down analysis, derivatives that are used to hedge non-trading positions (e.g. MSR, structural interest rates, balance sheet management, etc.) are not themselves required to be actively wound-down and may instead be reflected in the residual portfolio (see also "DER 1. U.S. Resolution Strategy and Wind-Down Scenarios; Applicability" and Question 1 at "DER 2. Hedging and Interaffiliate transactions").
Q3. Should derivatives transactions between a surviving U.S. IHC subsidiary and all affiliates be reflected in the U.S. resolution strategy and the wind-down analyses required in Section IX of the 2018 Guidance?
A3. If a surviving U.S. IHC subsidiary has entered into derivatives transactions with a nonsurviving U.S. entity, a U.S. branch, or any other affiliate entity (including a foreign affiliate), then those transactions should be reflected in any analysis of the surviving U.S. IHC subsidiary's derivatives portfolio.
For example, where a surviving U.S. IHC subsidiary has hedged a position on its books by entering a derivatives transaction with a nonsurviving entity, the analysis should capture the effect of the nonsurviving entity's default with respect to the transaction (e.g., any uncovered exposure, cost of any replacement hedge, and increase in P&L volatility). Similarly, where a surviving U.S. IHC subsidiary has entered a transaction with an affiliate that is assumed to continue operating and performing on its inter-affiliate transactions those transactions should be reflected in the firm's active wind-down analysis, including the impact of replacing, novating, compressing or otherwise winding-down those affiliate positions.
DER 3. Stabilization/Ratings/Playbooks
Q1. How should a firm determine criteria or assumptions regarding market expectations for the sufficient capital and liquidity levels of a surviving U.S. IHC subsidiary with derivatives positions?
A1. In determining the criteria or assumptions regarding market expectations, a firm should, consistent with its U.S. strategy, consider (1) its current counterparty credit risk management approach for dealing with financial counterparties in stress, (2) its experience in dealing with stressed counterparties during the 2008 crisis, and (3) criteria utilized by the rating agencies, as applicable. At a minimum, a surviving U.S. IHC subsidiary with derivatives positions should meet any applicable regulatory capital requirements (consistent with the Q&A found at "CAP 2. Definition of ‘Well-Capitalized' Status" in the Capital section) and, as applicable, meet minimum FMU membership eligibility requirements.
Q2. Which U.S. IHC subsidiaries are covered by the requirement under Section IX of the 2018 Guidance to develop rating agency playbooks?
A2. Under Section IX of the 2018 Guidance, each surviving U.S. IHC subsidiary that conducts derivatives activities should have a well-developed rating agency playbook (that includes entity-specific considerations) for maintaining, reestablishing or establishing investment-grade ratings or the equivalent level of financial soundness necessary for that entity to continue transacting (see previous question).
Q3. Should a firm assume that its trading entities are downgraded to below investment grade at the point of non-viability?
A3. Under the passive wind-down analysis and the active wind-down analysis described in Section IX of the 2018 Guidance, each surviving U.S. IHC subsidiary with derivatives positions should be assumed to have failed to maintain, establish, or reestablish market confidence sufficient to continue as a transacting entity in the bilateral OTC markets.
A firm's U.S. resolution strategy should assume that, at the point of non-viability of the U.S. IHC, each surviving U.S. IHC subsidiary with derivatives positions is downgraded to below investment grade or otherwise fails to maintain, establish, or reestablish market confidence sufficient to continue as a transacting entity unless the firm provides well-supported analysis to the contrary.
DER 4. Trading Book Definitions
Q. What is the scope of activity covered in the wind down analyses required in Section IX of the 2018 Guidance, specifically with respect to non-trading derivatives and non-derivatives trading positions?
A. The wind-down analyses described in Section IX of the 2018 Guidance are focused on the wind-down of a firm's derivatives positions (trading and hedging positions; regardless of whether they are in the banking book or trading book). The Section IX wind-down analyses may also include non-derivative trading positions that are linked to specific derivatives transactions (for example, a firm might sell cash securities along with winding down the derivatives to rebalance risk positions over time). To the extent a firm includes such positions, the firm should present the analysis separately from the schedules specified in the 2018 Guidance Derivatives Appendix.
DER 5. Passive Wind-Down/Rump
Q1. Please clarify the particular approach to passive wind down expected by the Agencies.
A1. The passive wind-down analysis described in Section IX of the 2018 Guidance is intended to be a total run-off scenario whereby the wind-down of the firm's derivatives positions results from contractual maturities and limited client initiated terminations. A firm's estimates should be sensitive to the magnitude and nature of basis risks that would result from hedging with only exchange-traded and centrally-cleared instruments in a severely adverse stress environment--e.g., a portfolio comprised of short-dated, vanilla positions generally should have lower capital and liquidity impacts than a portfolio comprised of long-dated, complex positions.
The passive wind-down analysis should not include techniques such as compression and step-out, novations, risk neutral transfers of portfolios, or other discretionary client-risk reducing trades. This is a key difference between the passive wind-down analysis and active wind-down analysis.
Q2. In the wind-down analyses described in Section IX of the 2018 Guidance, do the Agencies expect projections of RWAs, liquidity, or both to determine when resource depletion occurs and with respect to the systemic risk profile analysis? Please provide more clarity around the Agencies' expectations for the systemic risk profile.
A2. For the passive wind-down analysis and the active wind-down analysis described in Section IX of the 2018 Guidance, a covered FBO should include estimated resource needs--i.e., capital and liquidity needs--over time, until the point of total run-off or when resources are depleted--e.g., when an applicable regulator would initiate proceedings for the relevant surviving U.S. IHC subsidiary. Consistent with Question 3 at "LIQ 2. Distinction between Liquidity Forecasting Periods" in the Liquidity section, resource needs can be estimated on a quarterly basis.
Bearing in mind the objectives of an orderly resolution, a covered FBO should assess the risk profile of the residual portfolio in a manner consistent with the attributes noted on page 26 of the 2018 Guidance: size, composition, complexity, and potential counterparties.
DER 6. Derivatives Sales/Active Wind Down
Q. May covered FBOs include the transfer of derivatives portfolios as part of larger line of business sales?
A. A firm's U.S. resolution strategy may include the transfer of derivative portfolios as part of broader line of business sales. In the event of such a transfer, firms should indicate whether or not the derivatives positions are linked to any securities or other positions and if such positions were included as part of the broader line of business sale. Separately, covered FBOs must also provide the passive wind-down analysis and the active wind-down analysis described in Section IX of the 2018 Guidance for each surviving U.S. IHC subsidiary with derivatives positions, which should not assume the transfer of derivatives portfolios as part of broader lines of business sales.
DER 7. Break Clauses
Q. In the wind-down analyses described under Section IX of the Guidance, is it permissible to assume that firms and clients will terminate, when able, derivatives contracts if the contracts with counterparties allow such breaks?
A. Client-initiated terminations. In the passive wind-down analysis and the active wind-down analysis described under Section IX, covered FBOs should assume that counterparties will exercise any contractual termination right, consistent with any rights stayed by the ISDA protocol, (i) that is available to the counterparty following the U.S. IHC's entry into an insolvency proceeding (e.g., optional early termination right) and (ii) if exercising such right would economically benefit the counterparty ("expected client-initiated terminations").
Firm-initiated terminations. In the passive wind-down analysis, a covered FBO cannot assume that it can terminate trades on derivatives contracts except where the termination is to facilitate the close-out of an expected client initiated-termination. For example, upon a client-initiated termination the firm may close-out the external or internal leg of a mirrored, back-to-back transaction with a counterparty or affiliates if the firm has the contractual right to terminate the transaction or it would be economically beneficial for the counterparty or affiliates to mutually consent to such termination.
In the active wind-down analysis, a covered FBO can initiate the termination of trades when it has the contractual rights to do so, such as in cancellable swaps and rights in similar instruments. The firm may also seek, and consent to, the termination of trades on derivatives contracts to facilitate novations and risk reducing trades consistent with Question 1 at "DER 2. Hedging and Interaffiliate transactions."
In all instances, including the firm's U.S. resolution strategy, assumptions regarding early terminations (regardless of whether the termination is initiated by the firm or its client) should be adequately supported by the underlying contract and economic benefits to the firm and/or counterparty.
DER 8. Risk Evolution of Derivatives in Wind Down
Q. What are the Agencies' expectations with respect to modeling the evolution of risk factors associated with the derivatives portfolio through the resolution period?
A. The Agencies have not imposed an expectation that firms should model the evolution of risk factors with respect to the passive wind-down analysis and the active wind-down analysis described in Section IX of the 2018 Guidance or in the context of a wind-down of its derivatives portfolio under its U.S. resolution strategy.
DER 9. Limitation on Access to Bilateral OTC Derivatives Markets
Q. Section IX of the 2018 Guidance regarding the passive wind-down analysis and the active wind-down analysis directs the covered FBOs to "assume that entities cannot access bilateral over-the-counter (OTC) markets." Please clarify the scope of that limitation and whether the limitation extends beyond OTC derivatives instruments to include bilateral securities financing transactions used to source collateral and securities?
A. The limitation noted above applies only to derivatives. For example, a firm may use reverse repo and stock borrow transactions to source collateral and securities so long as such transactions are on terms consistent with the plan's scenario assumptions regarding counterparty/market expectations.
DER 10. Indirect Access to FMUs During Wind-Down
Q. For the passive wind-down analysis and the active wind-down analysis described in Section IX of the 2018 Guidance, please clarify under which circumstances a firm may assume continued access through an affiliate to exchanges and other FMUs?
A. A firm may assume that an entity can retain access to exchanges and other FMUs through an affiliate where this relationship is established prior to resolution, and so long as its margin arrangements with that affiliate are on third-party terms (see also "OPS PCS 1. FMU Contingency Arrangements," Question 3, in the Operational: Payments, Clearing, and Settlement section)
DER 11. General Applicability.
Q. Does Section IX apply regardless of the size of a firm's U.S. derivatives portfolio?
A. Section IX of the 2018 FBO Guidance applies to a foreign-based covered company if it conducts derivatives and trading activities within any of its U.S. IHC subsidiaries. For nonsurviving entities, firms need only provide the analysis and explanation described on pages 27-28 of the Guidance.
References
4. "Surviving U.S. IHC subsidiary" means a U.S. IHC subsidiary that does not enter an insolvency proceeding contemporaneous with the U.S. IHC's entry into a bankruptcy proceeding. Return to text