Portfolio approaches and credit mitigation arrangements

When calculating derivative credit adjustments, reporting entities may factor in their ability to reduce their counterparty exposures through any existing netting or collateral arrangements.

The measurement exception in IFRS 13 allows a reporting entity to measure the net credit risk of a portfolio of derivatives to a single counterparty, assuming there is an enforceable arrangement in place that mitigates credit risk upon default (e.g., master netting agreement).

Collateral arrangements

In many instances, counterparty credit exposure in derivative transactions can be reduced through collateral requirements.

Such arrangements serve to limit the potential exposure of one counterparty to the other by requiring the OTM counterparty to post collateral (cash or liquid securities) to the ITM counterparty. While these and other credit mitigation arrangements often serve to reduce credit exposure, they typically do not eliminate the exposure completely.

Many collateral agreements do not require collateral to be posted until a certain threshold has been reached, and then, collateral is required only for the exposure in excess of the threshold. In addition, even when transactions with a counterparty are subject to collateral requirements, entities remain exposed to what is commonly referred to as ‘gap risk’ (= the exposure arising from fluctuations in the value of the derivatives before the collateral is called and between the time it is called and the time it is actually posted).

Finally, collateral arrangements may be either unilateral or bilateral.

Unilateral arrangements --> require only one party to the contract to post collateral

Bilateral agreements --> both counterparties subject to collateral requirements, potentially at different threshold levels.

Netting arrangements

A master netting agreement = legally binding contract between two counterparties to net exposures under other agreements or contracts (ex: ISDA agreements, CSAs and any other credit enhancements or risk mitigation arrangements in place) between the same two parties.

Such netting may be effected with respect to periodic payments (payment netting), settlement payments following the occurrence of an event of default (close-out netting) or both.

In cases of default, such an agreement serves to protect the parties from paying out on the gross amount of their payable positions, while receiving less than the full amount on their gross receivable positions with the same counterparty.

In situations where an entity passes the measurement exception criteria detailed in IFRS 13, it will still need to assess whether it has the practical ability to implement a credit valuation method which reflects the net counterparty exposure.

This can be challenging, particularly for those entities that do not have systems in place to capture the relevant net positions by debtor/counterparty. Also, an allocation of the portfolio level adjustments is required.

A further complication arises if the net exposure represents the position across different classes of derivatives (ex: IR swaps and FX forwards).

Basic valuation methods can attempt to approximate a net position through the creation of an appropriate ‘modelled net position’ representing the net risk.

Given their ability to reduce credit exposure, netting and collateral arrangements are typically considered in determining the CVA for a portfolio of derivatives.

This can add to the complexity of the calculation as total expected credit exposure must be determined not just for a single derivative contract (whose value changes over time), but for a portfolio of derivative contracts (which can include both derivative assets and derivative liabilities).

Simply taking the sum of the CVA of individual trades could dramatically overstate the potential credit exposure, as it would not take into account positions in the portfolio with offsetting exposures.

Consequently, when netting agreements and collateral arrangements are in place, and a company has elected to measure its derivative positions with offsetting credit risk using the measurement exception in IFRS 13, the expected exposure is generally analysed at the portfolio level (on a net basis).

Allocation of portfolio-level credit adjustments

The use of the measurement exception under IFRS 13 does not change the fact that the unit of account is the individual derivative contract, a concept particularly important when an individual derivative is designated as a hedging instrument in a hedging relationship.

In the absence of any guidance under IFRS for how portfolio level credit adjustments should be allocated to individual derivatives, we can look to practices that have evolved in the market.

Various quantitative allocation methods have been accepted in practice, based on the appropriate circumstances if consistently applied. These methods have been accepted as long as a reporting entity can support that the method is appropriate for its facts and circumstances and is applied consistently.

The following methods have been commonly used:

Relative fair value approach — the entity allocates a portion of the portfolio-level credit adjustment to each derivative asset and liability based on the relative fair value of each of the derivative to the fair value of the portfolio.
In-exchange or full credit approach — the entity uses the derivative‘s stand-alone fair value, which would take into account the credit standing of the parties and ignore the effect of the master netting arrangement. The benefit of this model is that it avoids the complexity of an allocation.
Relative credit adjustment approach — the entity allocates a portion of the portfolio-level credit adjustment to each derivative asset and liability based on the relative credit adjustment of each of the derivative instruments to the portfolio. This approach would require use of an in-exchange premise to calculate a credit adjustment for each instrument.
Marginal contribution approach — the entity allocates a portion of the portfolio-level credit adjustment to each derivative asset and liability, based on the marginal amount that each derivative asset or liability contributes to the portfolio-level credit adjustment.

Once allocated, the adjustment to the fair value of an individual derivative used as a hedging instrument must be incorporated into the assessment of that hedge’s effectiveness.

Given the renewed focus on credit adjustments, it is likely that valuation methods will become more sophisticated and new techniques and refinements to the above portfolio allocation techniques will arise.

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