Determination of exposure value cap for netting sets subject to a margin agreement.

CRR Art. 274 (3) states that the exposure value of a netting set that is subject to a margin agreement may be capped at the exposure value of the same netting set assuming it would not be subject to a margin agreement. In this context the question arises if variation margin that the institution has already received or posted should be disregarded in order to determine this cap.

The exposure value cap was introduced in order to avoid that high threshold amounts inflate the EaD, see BCBS CRE 52.2 “The capping of the exposure at default (EAD) at the otherwise unmargined EAD is motivated by the need to ignore exposure from a large threshold amount that would not realistically be hit by some small (or non-existent) transactions”. If the unmargined methodology is applied to determine the Replacement Cost (RC) then CRR Art. 275(1) includes a formula that does not explicitly include Variation Margin (VM) which makes sense as typically there will be no VM in case of an unmargined netting set. The formula does include the Net Independent Collateral Amount (NICA) that is defined as the net collateral received or posted other than VM. If now the unmargined RC methodology is applied for the purposes of the cap, the question arises if the actual VM posted or received should be disregarded when applying Art. 275(1), or if in this specific case it should be included in the definition of NICA. The same question arises on the level of the BCBS text where the same formula is used and in addition the RC is defined as “For unmargined transactions, the RC intends to capture the loss that would occur if a counterparty were to default and were closed out of its transactions immediately.” (BCBS CRE52.3)   In our view VM posted received should be included in the RC formula used to determine the cap for the following reasons:   Firstly the unmargined RC formula aims to determine the loss that would occur if a counterparty were to default immediately. In order to achieve this stated objective, it is mandatory to include VM posted/ received as otherwise this loss is over- or understated depending on the actual VM amounts posted or received.   Secondly a similar question is addressed by BCBS CRE 52.10 in the context of one way CSAs where the bank posts VM. As in this case the unmargined RC formula must be applied, the same question arises if VM should be disregarded for the RC calculation as the formula does not explicitly include VM. On the BCBS level footnote 2 states that in this case NICA should be determined such that it includes VM and hence VM is not disregarded in the determination RC. In our view a similar interpretation should apply for Art. 274 (3), i.e. when the unmargined RC methodology is applied for the purposes of the cap, then VM posted/ received is included in the term NICA and hence is not disregarded.