Mandatory substitution approach according to Article 403 when applying the CCR exposure value calculation as set out in Sections 3 to 5 of Chapter 6 of Title II of Part Three of Regulation (EU) No 575/2013 (Derivatives and Long Settlement Transactions)

Is the mandatory substitution approach according to Article 401 (4) detailed in Article 403 of the CRR to be applied when an institution uses SA-CCR, Simplified SA-CCR or OEM for the derivative business? If yes, what is the amount that the institution shall assign to the protection provider/collateral issuer? Also, what will be considered as original direct exposure value to be reduced by the amount assigned to the protection provider/collateral issuer?

The treatment of mitigants already incorporated in the calculation of EAD for CCR exposure measurement as set out in Sections 3 to 5 of Chapter 6 of Title II of Part Three of Regulation (EU) No 575/2013 is not addressed under CRR articles 399, 401 and 403. As per answers to EBA QA 2020_5496, questions 2 and 3, for the CCR exposures rising from SFTs under contractual master netting agreements, the portion of the exposure to be assigned to the third party protection provider/collateral issuer ‘is the value of that collateral recognised as reducing the exposure to the client for the purpose of calculating own funds requirements. This value is determined as the difference between the exposure amount calculated without recognising that collateral (all other things being equal) and the exposure amount calculated recognising that collateral (all other things being equal)’. In the context of the CCR exposure measurement for derivative business with the distinction of exposure before and after CRM, there is also EBA QA 2021_6300 answer that summarized the EAD pre-CRM value calculation to 'apply EAD formulas as if the netting set is unmargined and no form of collateral is accepted’.     Considering the above answers and the expected behaviour for large exposure purposes of treating the portion of the exposure by which the exposure to the client has been reduced as having been incurred with the protection provider rather than the client, please consider below case and possible outcomes: Contractual netting agreement with CPTY A, the contractual terms implying an independent initial collateral provided by CPTY A in the form of securities issued by a third entity and exchange of variation margin is expected, margin to be given by the parent of CPTY A. On top of the contractual netting agreement, the reporting institution received unfunded credit protection in the form of guarantee from own parent entity.    DER1 100 (market value); DER2 200 (market value); Initial security collateral received from CPTY A, issuer CPTY C -30 (nominal value); Cash Variation Margin received from CPTY B (ultimate parent of CPTY A) -50 (nominal value); Guarantee provided by BANK X, parent of the reporting institution (to mitigate risk of CPTY A default) -300 (nominal value). Assume PFE of 5 for simplification reasoning. CPTY A expected EAD Pre-CRM (as per EBA QA 2021_6300): 427 CPTY A EAD: 315 Unfunded credit protection on top of CCR, for capital requirement calculation: CPTY A CCR exposure unmitigated: 15 CPTY A CCR exposure mitigated: 300 (expecting lower or equal risk weight as for the unmitigated portion) If the risk weight associated with all mitigant providers would be lower or at least equal to that of CPTY A, by applying the substitution approach for large exposure measurement, following out scenarios are viewed: Scenario 1 CPTY A: original direct exposure of 427, of which outflow via CRM substitution -412 CPTY B: original indirect exposure of 70 (margin* alpha) CPTY C: original indirect exposure of 42 (nica *alpha) BANK X: original indirect exposure of 300 (unfunded credit protection)   The concern for this scenario is that the original direct exposure with CPTY A will no longer reflect CCR exposure value as set out in Sections 3 to 5 of Chapter 6 of Title II of Part Three of Regulation (EU) No 575/2013, no longer fitting the expectation as per ITS Annex 9 Definitions and general instructions point (17)  ‘The exposure value of derivative contracts listed in Annex II of CRR and of credit derivative contracts directly entered into with a client shall be determined in accordance with Part Three, Title II, Chapter 6, CRR with the effects of contracts of novation and other netting agreements taken into account for the purposes of those methods in accordance with Part Three, Title II, Chapter 6, Section 3 to Section 5, CRR.’. Furthermore, as per DPM data point definitions, the same concept is reported in C 07.00.a column 0010 (metric “mi180”, original exposure pre conversion factors) where ITS Annex 2 reporting instructions for original exposure clearly state that ‘For Derivative instruments, repurchase transactions, securities or commodities lending or borrowing transactions, long settlement transactions and margin lending transactions subject to counterparty credit risk (Part Three, Title II, Chapter 4 or Chapter 6 of Regulation (EU) No 575/2013) the original exposure shall correspond to the Exposure Value for Counterparty Credit Risk (see instructions to column 0210).’, hence Solution 1 will lead to a misalignment between original exposure value understanding.   Scenario 2 Alternative Scenario 2 would be to ignore, for large exposure measurement, the existence of indirect exposure with the providers of mitigants already consumed in the EAD calculation, hence output would look as follows:    CPTY A: original direct exposure of 315, of which outflow via CRM substitution -300 BANK X: original indirect exposure of 300 (unfunded credit protection) In this scenario the information of EAD Pre-CRM will not be considered, including the possible indirect exposure assignable to the margin provider.