Barclays 2012 Annual Report Download - page 330

Derivative credit risk
The Group buys and sells financial instruments that are traded or
cleared on an exchange, including interest rate swaps, futures and
options on futures. Holders of exchange traded instruments provide
margin daily with cash or other security at the exchange, to which the
holders look for ultimate settlement.
The Group also buys and sells financial instruments that are traded
over the counter, rather than on a recognised exchange. These
instruments range from standardised transactions in derivative
markets, to trades where the specific terms are tailored to the
requirements of the Group’s customers. In many cases, industry
standard documentation is used, most commonly in the form of a
master agreement, with individual transaction confirmations. The
existence of a signed master agreement is intended to give the Group
protection in situations where a counterparty is in default.
Counterparty credit exposure arises from the risk that parties are
unable to meet their payment obligations under certain financial
contracts such as derivatives, securities financing transactions
(e.g. repurchase agreements), or long settlement transactions.
Internal capital for counterparty credit risk is assessed and allocated
based on the economic capital for wholesale credit risk calculation. The
magnitude of the exposure is determined by considering the current
mark to market of the contract, the historic volatility of the underlying
asset and the time to maturity. This allows calculation of a Credit
Equivalent Exposure (CEE) for such exposures. The total economic
capital for a portfolio of such exposures is then calculated in a manner
similar to a book of loans.
‘Wrong-way risk’ in a trading exposure arises when there is significant
correlation between the underlying asset and the counterparty, which
in the event of default would lead to a significant mark to market loss.
When assessing the credit exposure of a wrong-way trade, analysts
take into account the correlation between the counterparty and the
underlying asset as part of the sanctioning process.
Adjustments to the calculated CEE are considered on a case by case
basis. In the case of specific wrong-way risk trades, which are
self-referencing or reference other entities within the same
counterparty, specific approval by a senior credit officer is required.
Netting and collateral arrangements
Credit risk from derivatives is mitigated where possible through netting
agreements whereby derivative assets and liabilities with the same
counterparty can be offset. Group policy requires all netting
arrangements to be legally documented. The ISDA Master Agreement
is the Group’s preferred agreement for documenting over the counter
(OTC) derivatives. It provides the contractual framework within which
dealing activities across a full range of OTC products are conducted
and contractually binds both parties to apply close-out netting across
all outstanding transactions covered by an agreement if either party
defaults or other predetermined events occur. The majority of the
Group’s OTC derivative exposures (excluding those cleared via a central
clearing counterparty) are covered by ISDA master netting and ISDA
Credit Support Annex (CSA) collateral agreements.
Collateral is obtained against derivative assets, depending on the
creditworthiness of the counterparty and/or nature of the transaction.
Any collateral taken in respect of OTC trading exposures will be subject
to a ‘haircut’ which is negotiated at the time of signing the collateral
agreement. A haircut is the valuation percentage applicable to each
type of collateral and will be largely based on liquidity and price
volatility of the underlying security. The collateral obtained for
derivatives is either cash, direct debt obligation government (G14+)
bonds denominated in the domestic currency of the issuing country,
debt issued by supranationals or letters of credit issued by an
institution with a long-term unsecured debt rating of A+/A3 or better.
Where the Group has ISDA master agreements, the collateral
document will be the ISDA CSA. The collateral document must give
Barclays the power to realise any collateral placed with it in the event of
the failure of the counterparty, and to place further collateral when
requested or in the event of insolvency, administration or similar
processes, as well as in the case of early termination.
Under IFRS, netting is permitted only if both of the following criteria are
satisfied:
 the entity has a legally enforceable right to set off the recognised
amounts; and
 the entity intends either to settle on a net basis, or to realise the asset
and settle the liability simultaneously.
Under US GAAP, netting is also permitted, regardless of the intention to
settle on a net basis, where there is a counterparty master agreement
that would be enforceable in the event of bankruptcy.
Derivative counterparty credit risk measurement (Credit Value
Adjustments)
Barclays participates in derivative transactions, and is therefore
exposed to counterparty credit risk (or ‘counterparty risk’). This is the
risk that a counterparty will fail to make the future payments agreed in
the derivative contract. This is considered as a separate risk to the
volatility of the mark to market payment flows. Modelling this
counterparty risk is an important part of managing credit risk on
derivative transactions.
The counterparty risk arising under derivative transactions is taken into
account when reporting the fair value of derivative positions. The
adjustment to the value is known as Credit Value Adjustment. It is the
difference between the value of a derivative contract with a risk free
counterparty and that of a contract with the actual counterparty. This
is equivalent to the cost of hedging the counterparty risk, which is
replicated by purchasing and selling credit default swaps (CDS) on the
counterparty to create a hedge position that mirrors the Expected
Exposure profile for the counterparty.
Credit Value Adjustment for derivative positions are calculated as a
function of the ‘Expected Exposure’, which is the average of future
hypothetical exposure values (or mark to market) for a single
transaction or group of transactions by the same counterparty, and the
CDS spread for a given horizon.
In order to calculate the Expected Exposure, the expected mark to
market is calculated using Monte Carlo simulations of risk factors that
may affect the valuation of the derivative. These simulations include
credit mitigants such as exposure netting, collateral, mandatory break
clauses and set-off clauses. Counterparties with appropriate credit
mitigants will generate a lower Expected Exposure profile compared to
counterparties without credit mitigants in place for the same derivative
transactions.
barclays.com/annualreport328 I Barclays PLC Annual Report 2012
Risk management
Credit risk management continued