Large exposure treatment of structured derivatives, such as collar financing transactions (‘CFTs’)

For the purposes of large exposures (‘LE’), what is the appropriate treatment for structured derivatives (like covered calls, CFTs, etc.) in the application of the mandatory substitution (‘risk shifting’) rule in accordance with CRR Article 401(4) that requires an institution to treat the portion of the exposure collateralised by the market value of funded credit risk mitigation (‘CRM’) as exposure to the third party (collateral issuer) rather than to the client?

Firstly, consider the instance of a covered call where, for example, a purchased call option is collateralised by the shares referenced by the option. In this case, if the shares default and so fall in value, then the option will expire worthless so there is no receivable from the client. Conversely, if the option has value, and thereby generates counterparty risk, then the shares must also be still performing and therefore be good collateral. Any risk to the shares will therefore be captured through market risk and the corresponding issuer risk for LE purposes. Consequently, requiring risk shifting as well would be duplicative. Another structured derivative example is CFTs that provide clients with financing for their investment in a particular stock, limiting upside potential (short call) in exchange for downside protection (long put).  Unlike most other collateralised derivatives, the underlying shares of the call and put contracts that together form a ‘collar’, are posted by clients as collateral (either on a rehypothecatable or non-rehypothecatable basis) for financing. As the CFT structure includes the sale of a put option to the counterparty, any fall in collateral value supporting the client receivable (from the financing or call option) would be offset by the increase in value of the put option the client has with the institution. Economically, there is no counterparty credit risk as the institution will never have any receivable from clients under any scenario (i.e. either the collateral has value to cover any potential receivable from the financing or call option or, if the collateral issuer defaults and the underlying share value falls, the bank will have a payable to client under the put option). Furthermore, each CFT transaction will have an external legal opinion that all elements within the CFT can be netted in the event of client default. For LE purposes, the exposures considered for the CFTs are counterparty credit risk (CCR) and issuer risk, summarised as follows: Exposure to the client: CCR on the structured derivative (put/call/financing/collateral) is measured using SA-CCR after considering the effects of the collateral received as CRM (CRR Article 390(4)) Exposure to the share issuer via the collar (issuer risk): the default of the underlying shares on the put and call option is subject to market risk (Article 390(5)) Exposure to the share issuer via ‘risk shifting’: this amount is determined as the difference between the SA-CCR exposure with and without CRM (Article 401(4)). Items (2) and (3) above are duplicative - the risk in (3) of the collateral issuer defaulting is already captured in the issuer risk requirement for the put and call option in (2) and does not lead to a further loss for the institution.  Under a CFT, the equivalent number of shares received as collateral are also those referenced in the short put and long call option.  Per Article 390(5), the LE rules already capture the risk on the default of the shares referenced in the put and call option. The shares cannot default twice and therefore risk shifting an amount to the collateral issuer as well would be double counting this risk. In the event of collateral issuer default, the institution will always have a payable to the client due to the short put option.