Eligible hedge of Credit Valuation Adjustment (CVA)

Importantly, the recognition of any hedging instrument as an eligible hedge is subject to the necessary condition that it has to be used for the purpose of mitigating CVA risk and managed as such, per Article 386(1) of Regulation (EU) No 575/2013 (CRR). Under the advanced method set out in Article 383 of the CRR, credit default swaps, credit linked notes, total return swaps and vanilla CDS swaptions (both American and European styles) on a single-name reference entity or an index can be considered as eligible hedges according to Article 386 as long as they are included in the scope of the internal model for the specific risk of debt instruments for which an institution has been granted permission to use in accordance with Article 363. Any eligible hedge has to be included in the standalone calculation of the own funds requirements for CVA risk performed under Article 383 for its credit spread risk. It remains, however, included in the calculation of the own fund requirements for general market risk for any other material risks such as general interest rate risk or volatility risk. Under the standardised method set out in Article 384 of the CRR, only credit default swaps and credit linked notes on a single-name reference entity or an index can be considered as eligible hedges according to Article 386. In this case, credit linked notes will be treated as credit default swaps under Article 384 of the CRR. Total return swaps, CDS swaptions or any other instruments will not be recognised as eligible hedges since the calculation formula of the capital requirements under Article 384 of the CRR does not allow their risks to be captured in an adequate manner. According to Article 386(2) of the CRR, any other variants of these instruments (e.g. tranches, nth-to-default, CDS swaptions with barriers) will not be recognised as eligible hedges. If the contract contains a knock-out clause, i.e. the option contract is terminated following a credit event, it should not be considered as an eligible hedge, neither for the advanced nor the standardised method.