Mark-to-Market Method: Application of perfectly matching provisions to FX forwards

Can the perfectly matching rule be applied to the below two FX forwards (assuming the same maturity date and same counterparty) that are perfectly matching with respect to the EUR leg: FX forward 1: Bank pays USD 150 in return for EUR 100 FX forward 2: Bank pays EUR 100 in return for JPY 1320 such that the Mark-to-Market method is based on a single FX forward where the bank pays USD 150 in return for JPY 1320?

In Article 298 (2), the CRR allows to treat perfectly matching contracts included in a netting agreement as if they would be a single contract with a notional principal equivalent to the net receipts. Perfectly matching contracts are defined as ‘forward foreign-exchange contracts or similar contracts in which a notional principal is equivalent to cash flows if the cash flows fall due on the same value date and fully in the same currency without specifying that it needs to be the same currency pair. A straightforward application of the above rule are e.g. the following three FX forward contracts with the same maturity (portfolio 1): FX forward 1: Bank pays USD 150 in return for EUR 100 FX forward 2: Bank pays EUR 100 in return for JPY 1320 FX forward 3: Bank pays JPY 1320 in return for USD 150 The above three contracts fulfil all three regulatory criteria, i.e. - a notional principal is equivalent to cash flows, and - the cash flows fall due on the same value date, and - the cash flows fall due in the same currencies. Applying the perfectly matching provisions to the above trades results in a net receipt of zero and hence the applicable add-on is zero. Note that is result is economically adequate as the FX risk of the three FX forwards completely cancels out. Our question is if the perfectly matching principle illustrated via the three trades above can also be generalized to the example of the following two FX forwards with the same maturity (portfolio 2): FX forward 1: Bank pays USD 150 in return for EUR 100 FX forward 2: Bank pays EUR 100 in return for JPY 1320 The above two contracts are perfectly matching with respect to the EUR leg that completely cancels out. Hence an application of the perfectly matching rule with respect of the EUR leg results in an FX forward where the bank pays USD 100 and receives JPY 1320. Note that this result is economically sensible and directly follows from the first example if the following portfolio 3 is considered: FX forward 1: Bank pays USD 150 in return for EUR 100 FX forward 2: Bank pays EUR 100 in return for JPY 1320 FX forward 3: Bank pays JPY 1320 in return for USD 150 FX forward 4: Bank pays USD 150 in return for JPY 1320 Portfolio 3 is identical to portfolio 2 above as trades 3 and 4 cancel out. Applying the perfectly matching provisions as per portfolio 1 demonstrates that FX forwards 1, 2 and 3 are perfectly matching and result in an add-on of zero. Hence the add-on is determined based on FX forward 4 only. This demonstrates that applying the perfectly matching provisions as proposed for portfolio 2 is a straightforward generalization of the perfectly matching principle as illustrated by portfolio 1. Note further that if the application of the perfectly matching provision as per portfolio 2 would not be allowed, then the Mark-to-Market method would assign different add-ons to portfolio that are economically equivalent (portfolio 3 vs. portfolio 2) and that this would create an incentive for banks to enter into trades (i.e. trades 3 and 4 in portfolio 3) for no other reason than to reduce the add-on as per the Mark-to-Market method. Note that applying the perfectly matching provisions as per portfolio 2 is also economically sensible and is aligned to both risk management and settlement practice. The market risk manages and settles FX forwards and FX swaps on a currency and cash-flow basis, not a currency pair basis. For example the widely used settlement system CLS collapses portfolio 2 above in a USD 150 payable and a JPY 1320 receivable, i.e. acknowledges that the two trades are perfectly matching with respect to the EUR leg.