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Federal Reserve Bank OF DALLAS ROBERT D. M c T E E R , J R . P R E S ID E N T A N D C H IE F E X E C U T IV E O F F IC E R June 14 1995 DALLAS, TEXAS 75265-5906 N o tice 95-55 TO: The Chief Executive Officer of each member bank, bank holding company, and foreign agency in the Eleventh Federal Reserve District S U B JE C T Supervisory In form ation —D erivatives A ctivities o f B an k s an d S ecu rities Firm s D ETA ILS The Basle Committee on Banking Supervision and the Technical Committee of the International Organisation of Securities Commissions (IOSCO) has issued a joint framework for supervisory information about the derivatives activities of banks and securities firms. This joint framework, which is being issued to supervisors of banks and securities firms, is part of a continuing effort to improve supervisors’ access to, and evaluation of, timely and comprehensive information about institutions’ activities involving over-the-counter and exchange-traded derivatives. The joint framework has two main parts. The first part summarizes the risks associated with derivatives (e.g., credit risk, liquidity risk, m arket risk) and discusses qualitative and quantitative information that supervisors could obtain to assess these risks. The paper also discusses earnings information that may be useful for supervisory analysis purposes. The second part of the paper sets forth a common minimum supervi sory inform ation framework that focuses on a baseline of information that is useful for supervisors to begin assessing the impact of derivatives on an institution’s risk pro file—primarily, information about the extent of an institution’s derivatives activities and their credit risk. The two committees plan to periodically update the joint supervisory inform ation framework and to incorporate information about m arket risk into its common minimum framework at a later stage. For additional copies, bankers and others are encouraged to use one of the following toll-free numbers in contacting the Federal Reserve Bank of Dallas: Dallas Office (800) 333 -4460; El Paso Branch Intrastate (800) 592-1631, Interstate (800) 351-1012; Houston Branch Intrastate (800) 392-4162, Interstate (800) 221-0363; San Antonio Branch Intrastate (800) 292-5810. This publication was digitized and made available by the Federal Reserve Bank of Dallas' Historical Library (FedHistory@dal.frb.org) ATTACHM ENT A copy of the joint Basle Com m ittee/IOSCO supervisory information framework, including an Executive Summary on pages i - iv, is attached. M O R E IN F O R M A T IO N For m ore information, please contact Gail Teague at (214) 922-6151 or Julie Mills at (214) 922-6229. For additional copies of this Bank’s notice, please contact the Public Affairs D epartm ent at (214) 922-5254. Sincerely yours, Framework for supervisory information about the derivatives activities of banks and securities firms Joint report by the B asle C om m ittee on B an k in g Su p ervision and the T echnical C om m ittee o f the In tern ation al O rgan isation of Securities C om m ission s (" IO S C O " ) M ay 1995 Contents Page EXECUTIVE SUMMARY i-iv I. Introduction 1 II. Catalogue of information for supervisory purposes 6 1. Credit risk 2. Liquidity risk 10 3. Market risk 12 4. Earnings III. Common minimum information framework Annex 1: Framework for supervisory information on derivatives activities Annex 2: Derivatives data elements and their uses Annex 3: Common minimum information framework Annex 4: Definitions for elements o f the common minimum information framework 7 14 16 EXECUTIVE SUMMARY This paper presents a framework for supervisors to assess information about the derivatives activities o f banks and securities firms. It has been developed jointly by the Basle Committee on Banking Supervision and the International Organisation o f Securities Commissions (IOSCO) and is being distributed to banking and securities supervisors world wide. The framework is intended to enhance the information available to supervisors on the exchange-traded and over-the-counter (OTC) derivatives activities o f banks and securities firms. Given the rapid growth o f derivatives in recent years, it is important that supervisors continuously improve their understanding of how these instruments affect the overall risk profile and profitability o f banks and securities firms. The framework therefore presents the type o f information that the two Committees believe should be available within regulated firms and their material affiliates active in the derivatives markets and that should be accessible to supervisors. In this sense, it represents an elaboration on the papers released jointly by the Basle Committee and the IOSCO Technical Committee in July 1994 on the subject o f management controls. Mindful o f the need to limit regulatory burden, the framework provides for the assessment of supervisory information through a series o f channels, including on-site examinations and external audits, discussions with institutions, special surveys, as well as regular reporting procedures. The overall supervisory information framework presented in this paper consists o f two main parts. The first is a "catalogue" of information that the Committees have identified as important for an evaluation o f derivatives risks and that supervisors may draw from as they expand their reporting systems. The second is a common minimum framework o f data elements (a subset o f the catalogue) that the two Committees recommend that member supervisors have available to them. The paper is organised into three sections, each o f which is summarised below. I. Introduction In addition to providing a general overview o f the paper, the introduction discusses a series o f basic principles that underlie the overall supervisory information framework. These include the following: • Supervisory data should be comprehensive, i.e. it should cover all types o f derivative instruments and their major related risks and shed light on how derivatives contribute to an institution's overall business and risk profile. Where appropriate, derivatives positions should be evaluated together with related on-balance-sheet positions (e.g. for the purpose (ii) o f assessing market risks and earnings). Quantitative information on derivatives needs to be evaluated in the context o f qualitative information on an institution's overall risk profile and its ability to manage this risk. • Supervisors should attempt to obtain a comprehensive picture o f an institution's derivatives activities across different legal entities and jurisdictions. • The derivatives activities o f an institution can change rapidly, affecting an institution's risk profile and profitability. Data on derivatives should therefore be assessed with sufficient frequency to give a meaningful and timely picture o f the risks faced by an institution. • To limit the regulatory burden, supervisors are encouraged to draw on information that banks and securities firms generate for internal purposes. There should be as much consistency as possible between information obtained for reporting purposes and data that institutions must already compile for the purpose o f complying with other supervisory requirements. In light o f the different institutional, accounting and public policy approaches to supervision across the member countries o f the two Committees, each supervisory authority has flexibility to implement the common minimum framework in a manner best suited to its regulatory environment. • Each supervisor would apply the common minimum framework to internationally active institutions with significant derivatives operations, with flexibility also to extend the framework to other institutions with significant involvement in derivatives. II. Catalogue o f information for supervisory purposes The catalogue o f data items represents information that supervisors have identified as important for assessing the risks arising from firms' derivatives activities. It is intended to facilitate the development among supervisors o f consistent conceptual methods for assessing the risk exposures related to derivatives. It is also intended to provide a basis for discussion between firms and their supervisors about the type o f information that a firm should be aiming to maintain as part o f its overall risk management control mechanism. In this context, supervisors should seek to ensure that the firm has both quantitative and qualitative information on its derivatives activities. The information identified in the catalogue covers the following broad areas: Credit risk: Credit risk is the risk that a counterparty may fail to fully perform on its financial obligations. The framework focuses on the credit risk o f OTC derivatives rather than exchange-traded derivatives, for which a reduction in risk is achieved through an organised exchange or clearing house where there is payment and receipt o f margin. The primary measures of credit risk are current credit exposure and potential credit exposure, taking into account the risk reducing effects of legally enforceable netting agreements. In addition, the framework covers information on credit enhancements for both current and potential credit (iii) exposure. Finally, the framework discusses ways to assess the concentration o f credit risk and counterparty credit quality. Liquidity risk: Two types o f liquidity risk that can be associated with derivative instruments are covered in the framework: market liquidity risk and funding risk. Market liquidity risk is the risk that a position cannot be eliminated quickly by either liquidating the instrument or by establishing offsetting positions. Funding risk is the risk that derivatives positions place adverse funding and cash flow pressures on an institution. Market risk: Market risk is the risk that the value o f on- or off-balance-sheet positions will decline before the positions can be liquidated or offset with other positions. The framework covers two approaches for assessing market risks. One is to focus on position data that would allow independent supervisory assessment o f an institution's market risks through some supervisory model. The other is to evaluate information on an institution's internal estimates o f market risks. These estimates could be based on value-at-risk methodologies, as well as cn other approaches such as duration analysis, gap analysis, or scenario methods. Earnings: The framework discusses various types o f information important for assessing the impact o f derivatives on an institution's earnings profile. This includes information on trading income, broken down by broad risk classes (interest rate risk, foreign exchange risk and commodities and equities exposures), witho .t regard to the type o f instrument. The paper also suggests that a finer disaggregation o f earnings could be useful for supervisory purposes. In addition, the framework discusses the importance of assessing information on both unrealised and realised derivatives losses. Each o f these areas o f supervisory interest is presented in tabular form in Annexes 1 and 2 o f the paper. III. Common minimum reporting framework The two Committees recommend that member supervisors have available to them a minimum subset of the elements identified in the catalogue for large, internationally active banks and securities firms with significant involvement in the derivatives markets. The information contained in the common minimum framework represents a baseline of information that the Committees have identified as important for supervisors to begin assessing the nature and scope o f an institution's derivatives activities and how derivatives contribute to a firm's overall risk profile. It is intended that supervisors supplement the information in the common minimum framework with other information drawn from the catalogue of data items discussed above. (iv) The common minimum framework is illustrated in tables 1-5 o f Annex 3. Its focus is on information relating to credit risk, market liquidity risk and overall market activity. It is expected that supervisors will revisit the common minimum framework periodically to ensure that it is in line with the activities o f banks and securities firms, market innovations and the state o f supervisory reporting in member countries. For example, the minimum framework does not currently focus on market risks, an area that the Committees plan to address in the future. The Committees also intend to review the framework in light o f the planned efforts o f the Euro-currency Standing Committee o f G-l 0 central banks to collect, on a regular basis, aggregate market data on the derivatives activities o f financial institutions. Such co-ordination between banking and securities supervisors and central banks should minimise increases in reporting burden by avoiding inconsistencies and duplication in data collection, Framework for supervisory information about the derivatives activities o f banks and securities Firms I. Introduction (a) 1. Background The Basle Committee on Banking Supervision and the Technical Committee of the International Organisation o f Securities Commissions (IOSCO) have been working to enhance the prudential supervision o f the derivatives operations o f banks and securities firms.1 For example, in July 1994 the Basle Committee and the IOSCO Technical Committee jointly released documents providing guidance on the sound risk management of derivatives activities. 2. In their joint release o f the July 1994 documents, the Basle Committee and the IOSCO Technical Committee stated that they intended further consultations in the area of derivatives and other topics o f common interest. These consultations have led to an assessment o f the information necessary for effective supervision o f the derivatives activities of banks and securities firms. As a result o f this work, the Basle Committee and the IOSCO Technical Committee have designed and are distributing the information framework elaborated in this paper to supervisors o f banks and securities firms. T is framework describes information which the two Committees believe should be available within regulated firms and material affiliates active in the derivatives markets and that should be accessible to supervisors to assess the risks o f derivatives and their impact on institutions' financial condition, capital adequacy and performance. 3. Broadly defined, a derivative instrument is a financial contract whose value depends on the values of one or more underlying assets or indexes.2 While derivatives 1 The Basle Committee on Banking Supervision is a Committee o f banking supervisory authorities which was established by the central-bank Governors o f the Group o f Ten countries in 1975. It consists o f senior representatives o f bank supervisory authorities and central banks from Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, Netherlands, Sweden, Switzerland, United Kingdom and the United States. It usually meets at the Bank for International Settlements in Basle, where its permanent Secretariat is located. The Technical Committee o f IOSCO is a committee o f the supervisory authorities for securities firms in major industrialised countries. It consists o f senior representatives o f the securities regulators from Australia. Canada. France. Germany, Hong Kong. Italy, Japan, M exico, Netherlands. Spain, Sweden, Switzerland. United Kingdom, and the United States. : Examples o f derivative instruments include forward contracts and their variations, such as swaps. forward rate agreements and futures contracts, and option contracts and their variations, such as caps, floors and swaptions. -2generally involve risks to which banks and securities firms have long been exposed, the rapid growth and complexity o f these activities pose new challenges for firms and their supervisors. These challenges, together with the continuing growth o f derivatives activities, underscore the importance o f ensuring that firms maintain and supervisors have access to meaningful, timely information concerning financial institutions' derivatives activities, both exchange-traded and over-the-counter (OTC). 4. The overall supervisory information framework advanced in this paper consists o f two main components: 1) a catalogue discussing data that the Committees have identified as important for an evaluation o f derivatives risks and that supervisors may choose from as they expand their reporting systems and 2) a common minimum framework o f data elements (a subset o f the catalogue) to which relevant supervisory authorities should have access. The catalogue component o f the framework, discussed in section II, identifies the major types o f risks arising from derivatives activities and the information needed to evaluate those risks. The areas identified as o f particular interest to supervisors are credit risk, market risk, liquidity risk and earnings. 5. This catalogue o f data elements is intended to facilitate the development among supervisors o f consistent conceptual methods for assessing the risk exposures related to derivatives. The catalogue is also intended to serve as a basis for discussion between firms and their supervisors about the type o f information which the firm should be aiming to maintain as part o f its overall risk management control mechanism. In this context, the paper should be seen as an elaboration on aspects of the July 1994 papers on the sound management o f derivatives activities. While the catalogue has been developed for both banks and securities firms, some o f the items o f the catalogue may be more relevant for banking supervisors than for securities firm supervisors and vice versa. 6. The common minimum framework, which is discussed in section III, represents a baseline o f information that supervisors can use in assessing the impact o f derivatives on an institution's overall risk profile. The minimum framework focuses to varying degrees on information relating to credit risk, market liquidity risk and market activity.3 Individual supervisors can then supplement this information with other data elements drawn from the catalogue. 7. The minimum framework is also intended to provide a basis for co-ordinating supervisory reporting with other data collection initiatives on derivatives. In general, less information is available to supervisors on OTC derivatives than on exchange-traded derivatives, where statistics are available on the volume and value o f transactions and on open interest. In the case o f OTC derivatives, in most jurisdictions bank and securities supervisors 3 While the common minimum framework does not currently cover market risk, the two Committees plan to address this issue at a later stage. -3- do not collect information which gives an overall profile o f activity in such products. N or is such information currently available on a global basis. 8. Aggregated statistics on derivatives markets would be o f significant value to supervisors. The growing use o f OTC derivatives in conjunction with exchange-traded instruments reflects the financial market interrelationships between organised exchange markets, OTC derivatives activities and related underlying cash markets. This interrelationship between the markets underscores the need for supervisors to have access to timely and accurate information on OTC risk exposures o f major market participants as well as the overall activity in the OTC markets. 9. In this context, a minimum level o f harmonisation across G-10 countries o f supervisory information about derivatives could serve as an important input to the initiative o f the Euro-currency Standing Committee o f G-l 0 central banks to collect globally on a regular basis aggregate statistics on OTC and exchange-traded derivatives markets, both for macroeconomic and for macroprudential purposes. Under the Euro-currency Standing Committee initiative, data on the OTC and exchange-traded derivatives activities o f larger banks and securities firms, and other major derivatives dealers would be collected and aggregated. Co-ordination between supervisors and central banks on the data to be evaluated would help to reduce duplication o f efforts and thus limit the reporting burden for the banking and securities industry. 10. For the purpose o f this overall information framework, the mechanism for supervisory data analysis is not specified, allowing for the assessment o f information obtained through various channels. Specifically, information may be obtained and assessed through on-site examinations, discussions with institutions, special surveys or standard reports routinely submitted to supervisors and audited financial statements and other reports submitted by external auditors. The appropriate method for gathering information depends upon the nature o f the data, the institutions under review and the relevant supervisory authority. Certain information may be appropriate for all institutions whereas other types o f data may be meaningful only for larger dealers. (b) 11. Basic principles In developing an overall supervisory information framework for banks' and securities firms' derivatives activities, the two Committees have been guided by a number o f basic principles. In particular, the data should be comprehensive. It should cover all types o f derivative instruments and their major related risks and facilitate the supervisor's analysis o f how derivatives contribute to an institution's overall business and risk profile. The two Committees recognise that derivatives activities constitute only a part of the overall activities o f banks and securities firms. Consequently, derivatives should not be evaluated in isolation from the overall risks o f an institution. This implies, for example, that for purposes of assessing an institution's market risk and earnings profile, a portfolio approach incorporating -4related cash and derivatives positions - and, thereby, also the impact o f hedging and other risk management transactions - is required for meaningful interpretation. Moreover, quantitative information on derivatives activities needs to be seen in the context o f qualitative information on an institution's overall risk profile and its ability to manage this risk. 12. Comprehensive evaluation o f the risks o f derivatives generally implies the aggregation, consolidation and assessment o f information across a number o f activities and legal entities. Where institutions undertake business activities which fall under the jurisdiction o f different supervisors or where certain affiliates are not supervised, supervisors should discuss with regulated firms how best to assess information that provides a comprehensive, timely picture o f the risks associated with their overall derivatives and related activities. Bank supervisors should attempt to obtain information about these activities on a consolidated basis, while recognising the legal distinctions among subsidiaries. 13. Data on derivatives should be assessed with sufficient frequency and timeliness to give a meaningful picture o f an institution's risk profile. Derivatives activities may change dramatically due to changes in the types o f derivatives products involved and whether institutions are end-users o f such products to manage their risks or are acting as dealers. Changes in derivatives products and the role o f an institution as an end-user or dealer can affect the impact o f derivatives on an institution's risk profile and profitability. Therefore, it is important for supervisors to be aware o f new derivative instruments in a timely manner (particularly about higher risk and more complex instruments), how they are being used by institutions and how institutions' risk management systems are being enhanced to address these new developments. Moreover, it is important for supervisors to be aware in a timely manner o f significant increases in the derivatives exposures o f banks and securities firms. 14. The two Committees are aware o f the potential costs associated with requests for additional information on institutions' derivatives activities and recognise that additional information requirements should only arise where there is a clear supervisory need. To limit the regulatory burden, supervisors are encouraged to draw on information that banks and securities firms generate for internal purposes, where appropriate, for assessing the impact o f derivatives on financial condition and performance. Moreover, there should be as much consistency as is possible between information obtained for reporting purposes and data that institutions must already compile to comply with other supervisory requirements. The overall information framework should be sufficiently flexible to permit the incorporation o f new market innovations without requiring frequent updating o f the framework itself. The two Committees recognise that different institutional, accounting and public policy approaches to supervision require that each supervisory' authority have flexibility to implement the common minimum framework in a manner best suited to its regulatory environment. Each supervisor would apply the common minimum framework to internationally active institutions with significant derivatives operations, with flexibility also to extend the framework to other institutions with significant involvement in derivatives. -5 15. The common minimum information framework has been constructed with the aim o f achieving the assessment o f understandable and meaningful information about the derivatives activities o f banks and securities firms that could facilitate comparisons across institutions and, where possible, across countries. In this regard, it is intended that the overall information framework contribute to simplifying the regulatory reporting environment for banks and securities firms operating internationally. To the extent that the information is used for aggregation purposes, the Committees recognise the importance o f ensuring that the process o f aggregation not prejudice the confidentiality o f information obtained on individual institutions by their supervisory authorities. -6II. Catalogue of information for supervisory purposes 16. In monitoring the activities o f a financial institution involved in derivatives, supervisors need to be satisfied that the firm has the ability to measure, analyse and manage these risks. In order to achieve these objectives, supervisors should seek to ensure that the firm has both quantitative and qualitative information on its derivatives activities. 17. Quantitative information. Quantitative information about derivatives activities should address the following broad areas: - credit risk - liquidity risk - market risk - earnings Recognising that exchange-traded and OTC derivatives generally differ in their credit risk, liquidity risk and the potential for complexity, the overall reporting framework distinguishes between exchange-traded and OTC derivatives in identifying information needed for supervisory assessment. Each o f the four broad areas is discussed in greater detail in sections 1 to 4 below. 18. Qualitative information. In order to effectively evaluate banks' and securities firms' derivatives activities and related risks, supervisors should assess qualitative information about institutions' systems, policies and practices for measuring and managing the risks o f derivatives. This includes, for example, information on the risk limits that banks and securities firms use to manage their exposures and any changes in these limits. The risk management guidelines for derivatives, which were issued by the two Committees in July 1994 and which highlight key attributes o f the risk management systems o f banks and securities firms, may be used as a guide in requesting information on institutions' systems, policies and practices.4 19. The following sections describe in greater detail the different elements o f the framework for supervisory information about derivatives activities. The narrative discussion is summarised in tabular form in Annex 1. In Annex 1, two columns are provided for each o f the major risk categories. The first column identifies a supervisory concern or use, and the second column describes the information that could be applicable to that use. Explanations follow that summarise how each data item might be used or why it is important from a supervisory perspective. In general, the data and related explanations reflect widely accepted concepts and techniques for measurement of risk exposure that are based on new developments in practice. Some information elements address multiple supervisory uses listed 4 Risk M anagem ent Guidelines fo r D erivatives. Basle Committee on Banking Supervision, July 1994 and O perational and Financial Risk M anagem ent C ontrol M echanism s fo r O ver-the-C ounter D erivatives A ctivities o f R egulated Securities Firms. Technical Committee o f IOSCO, July 1994. -7in the first column o f Annex 1. To summarise such overlaps, Annex 2 cross-references the information elements with the supervisory uses that have been identified. 1. Credit Risk 20. Credit risk is the risk that a counterparty may fail to fully perform on its financial obligations. With respect to derivatives, it is appropriate to differentiate between the credit risk o f exchange-traded and OTC instruments. Owing to the reduction in credit risk achieved by organised exchanges and clearing houses, supervisors may need to evaluate less information on exchange-traded derivatives for credit risk purposes than on OTC instruments. Accordingly, the following discussion on credit risk pertains primarily to OTC contracts.5 21. The Committees recognise that the notional amount of OTC derivative contracts does not reflect the actual counterparty risk. Credit risk for an OTC contract is best broken into two components, current credit exposure to the counterparty and the potential credit exposure that may result from changes in the market value underlying the derivative contract. To the extent possible, credit risk from derivatives should be considered as part o f an institution's overall credit risk exposure. This should include exposure from other offbalance-sheet credit instruments such as standby letters o f credit as well as the credit risk from on-balance-sheet positions. (a) 22. Current credit exposure Current credit exposure is measured as the cost o f replacing the cash flow o f contracts with positive mark-to-market value (replacement cost) if the counterparty defaults. Legally enforceable bilateral netting agreements can significantly reduce the amount o f an institution's credit risk to each o f its counterparties. These netting agreements can extend across different product types such as foreign exchange, interest rate, equity-linked and commodity contracts. Therefore, an institution's current credit exposure from derivative contracts is best measured as the positive mark-to-market replacement cost of all derivative products on a counterparty by counterparty basis, taking account of any legally enforceable bilateral netting agreements. 23. For individual institutions, breaking out the gross positive and negative market values o f contracts may have supervisory value by providing an indication o f the extent to which legally enforceable bilateral netting agreements reduce an institution's credit exposure. 5 Credit risk is o f most concern in the case o f OTC derivative contracts since exchange clearing houses for derivatives employ risk management systems that substantially mitigate credit risks to their members. Both futures and options exchanges typically mark exposures to market each day. In the case o f futures exchanges, members' exposures to the clearing house are eliminated each day, and often intra-day, through variation margin payments. In the case o f options exchanges, clearing house exposures to written options are fully collateralised. - 8 - (b) Potential credit exposure 24. In light o f the potential volatility o f replacement costs over time, prudential analysis should not only focus on replacement cost at a given point in time but also on its potential to change. Potential credit exposure can be defined as the exposure o f the contract that may be realised over its remaining life due to movements in the rates or prices underlying the contract. For banks, under the requirements o f the 1988 Basle Capital Accord, potential exposure is captured through a so-called "add-on", which is calculated by multiplying the contract's gross or effective6 notional principal by a conversion factor that is based on the price volatility o f the underlying contract. Bank supervisors should therefore evaluate information on the add-ons that banks must already compile for their risk-based capital calculations. Such information could include notional amounts by product category (i.e. interest rate, foreign exchange, equities, precious metals and other commodities) and by remaining maturity (i.e. one year or less, over one year to five years and more than five years). The Basle Accord defines remaining maturity as the maturity o f the derivative contract. However, supervisors could also take into account information on the instrument underlying the derivative contract. 25. Some banks and securities firms have developed sophisticated simulation models that may produce more precise estimates o f their potential credit exposures than under the add-ons approach, and supervisors may wish to take account o f the results o f these models. These models are generally based on probability analysis and techniques modelling the volatility o f the underlying variables (exchange rates, interest rates, equity prices, etc.) and the expected effect o f movements o f these variables on the contract value over time. Estimates o f potential credit exposure by simulations are heavily influenced by the parameters used (a discussion o f the major parameters that can influence simulation results is included in the market risk section below). Supervisors and firms should discuss the parameters and other aspects o f the models to ensure an appropriate level o f understanding and confidence in the use of such models. (c) 26. Credit enhancements Information on credit enhancements used in connection with OTC derivative transactions is important to an effective supervisory assessment o f the credit risk inherent in an institution's derivatives positions. Collateral can be required by an institution to reduce both its current and potential credit risk exposure. Collateral held against the current exposure o f derivative contracts with a counterparty effectively reduces credit risk and, therefore, merits supervisory attention. However, supervisors need to consider the legal enforceability 6 Effective notional principal is obtained by adjusting the notional amount to reflect the true exposure o f contracts that are leveraged or otherwise enhanced by the structure o f the transaction. -9o f netting agreements and the quality and marketability o f collateral.7 For supervisory analysis purposes, collateral held by an institution in excess o f its netted credit exposure to a counterparty would not reduce current credit exposure below zero but could reduce potential credit exposure. Supervisors could obtain a better understanding o f how collateral reduces credit risk by collecting information separately on collateral with a market value less than or equal to the netted current exposure to the counterparty and collateral with market values in excess o f the netted current exposure and o f the nature o f that collateral. 27. OTC contract provisions that require a counterparty to post initial collateral (or additional collateral as netted current exposure increases) may be used to reduce potential credit exposure. An OTC contract that is subject to a collateral or margin agreement may have lower potential exposure, since collateral would be required in the future to offset any increase in credit exposure. Accordingly, information about the notional amount and market value o f OTC contracts subject to collateral agreements could enhance supervisory understanding o f an institution's potential credit risk. (d) 28. Concentration of credit risk As with loans, an identification o f significant counterparty OTC credit exposures relative to an institution's capital is important for an evaluation of credit risk. This information should be evaluated together with qualitative information on an institution's credit risk controls. To identify significant exposures and limit reporting burden, supervisors could focus on those counterparties presenting netted current and potential credit exposure above a certain threshold. As a minimum, supervisors could identify the 10 largest counterparties to which an institution is exposed, subject to the minimum threshold used. 29. Since counterparty exposure may stem from different instruments, overall risk concentrations with single counterparties or groups o f counterparties cannot be measured accurately if the analysis is limited to single instruments (e.g. swaps) or classes o f instruments (e.g. OTC derivatives). For this reason, institutions should aim to monitor counterparty exposures on an integrated basis, taking into consideration both cash instruments and offbalance-sheet relationships. Supervisors could also consider information on exposure to counterparties in specific business sectors or to counterparties within a certain country or region. 30. Supervisors could also analyse information on aggregate exposures to various exchanges, both on- and off-balance-sheet, and on exposures to certain types o f collateral supporting derivative instruments. Overexposure to specific issues or markets can lead to additional credit concerns, particularly in the case o f banks and securities firms with 7 For example, supervisors could obtain additional insights through information on OTC contracts with collateral recognised under the Basle Capital Accord (for banks) and OTC contracts with other readily marketable, high quality securities as collateral. - 10significant activity in securities markets. Some securities supervisors address this concentration risk by deducting from capital all positions above a certain level o f market turnover or by applying some other suitable benchmarks. Supervisors without such provisions should ensure that they are at least informed about these concentrations, whether in the form o f holdings o f the underlying security itself or in the form o f OTC derivatives positions which require the firm to deliver or receive such concentrated positions. (e) 31. Counterparty credit quality Credit risk is jointly dependent upon credit exposure to the counterparty and the probability o f the counterparty's default. Information on the current and potential credit exposure to counterparties o f various credit quality would increase supervisory insights into the probability o f credit loss. Information indicative o f counterparty credit quality includes total current and potential credit exposure - taking into account legally enforceable bilateral netting agreements - to counterparties with various characteristics, e.g. Basle Capital Accord risk weights (for banks), credit ratings assigned by rating agencies, or the institution's internal credit rating system. Information on guarantees, standby letters o f credit, or other credit enhancements may also enhance supervisory understanding o f credit quality. Aggregate information on past-due status and past-due information by major counterparties, together with information on actual credit losses, may be o f particular interest for identifying pending counterparty credit quality problems in the OTC derivatives markets. 2. Liqui ’ity risk 32. As with cash instruments, there are two basic types o f liquidity risk that can be associated with derivative instruments: market liquidity risk and funding risk. (a) 33. Market liquidity risk Market liquidity risk is the risk that a position cannot be eliminated quickly by either liquidating the instrument or by establishing an offsetting position. Information that breaks out exchange-traded and OTC derivatives could further supervisory understanding o f an institution's market liquidity risk. Although exchange-traded and OTC markets both contain liquid and illiquid contracts, the basic differences between the two markets give an indication o f the comparative difficulty o f offsetting exposures using other instruments.8 Among both OTC and exchange-traded products, information on broad risk categories (i.e., interest rate, foreign exchange, equities and commodities) and types o f instrument would be useful in judging the market liquidity o f an institution's positions. Accordingly, notional amounts and market values o f exchange-traded and OTC instruments by type (and perhaps by 8 Market illiquidity may stem from the customised nature o f some OTC contracts which can include fundamental elements o f market risk in combinations that may not be easily replicated using standardised exchange-traded contracts or other OTC instruments. - 11 maturity and by product) could enhance a supervisor's understanding o f an institution's market liquidity risk. In addition, supervisors could gain important insights into an institution's market liquidity by taking into account the availability o f alternative hedging strategies and closely substitutable instruments. 34. To understand the market liquidity risk arising from an institution's derivatives activities, supervisors would benefit greatly from a picture o f the aggregate size o f the market in which the institution is active. This is particularly important for OTC derivatives, which are generally tailored to the specific needs o f customers and for which marking to market is more difficult than for standardised products with liquid markets. As a result, it may be difficult to unwind a position in an appropriate time frame because o f its size, the availability o f suitable counterparties, or the narrowness o f the market. Currently available information on notional values o f derivative instruments provides, at best, an incomplete indication o f the aggregate size o f the market for a particular derivative instrument or o f an institution's participation in that market. An alternative, yet still imperfect, measure o f market size would be the gross positive and gross negative market values o f contracts by risk category or product. Such data would provide an indication o f the economic or market value of the derivative instruments held by banks and securities firms in a particular market at a point in time and an institution's concentration in that market. (b) 35. Funding risk Funding risk is the risk o f derivatives activities placing adverse funding and cash flow pressures on an institution. Funding risk stemming from derivatives alone provides only a partial picture o f an institution's liquidity position. In general, funding risk is best analysed on an institution-wide basis across all financial instruments. However, it is also important for supervisors to understand the impact o f derivatives on an institution's overall liquidity position. 36. Separate analysis o f notiona-l contract amounts o f exchange-traded and OTC instruments (as described earlier) should augment supervisory awareness o f funding risks, particularly given the requirements for margin and daily cash settlement o f exchange-traded instruments and the resulting demands for liquidity that large positions in these instruments may entail. For example, significant positions in OTC contracts hedged with exchange-traded instruments could result in liquidity pressures arising from the daily margin and cash requirements o f the exchange-traded products. Data on OTC contracts with collateral or other "margin-like" requirements may also be necessary for assessing liquidity risk. In addition, information about the notional amounts and expected cash flows of derivatives according to specified time intervals would be helpful in assessing funding risk. 37. Information on OTC contracts subject to “triggering agreements” provides further information about funding risk. Triggering agreements generally entail contractual provisions requiring the liquidation o f the contract or the posting of collateral if certain events, such as a - 12downgrade in credit rating, occur. Substantial positions in contracts with triggering agreements could increase funding risk by requiring the liquidation o f contracts or the pledging o f collateral when the institution is experiencing financial stress. Accordingly, information on the total notional amount and replacement cost o f OTC contracts (aggregated across products) with triggering provisions provides supervisors with important information about liquidity risk. 38. Supervisors should also consider evaluating information based on institutions' sensitivity analyses o f the effect o f adverse market developments on their funding requirements. This information would shed light on the potential for additional margin or collateral calls associated with exchange-traded and OTC derivatives positions due to changes in market variables such as interest rates and exchange rates. 3. 39. Market risk Market risk is the risk that the value o f on- or off-balance-sheet positions will decline before the positions can be liquidated or offset with other positions. Supervisors should assess information on market risk by major categories o f risk, such as interest rates, foreign exchange rates, equity prices and commodities. The market risk o f derivatives is best assessed for the entire institution and should combine cash and derivatives positions. The assessment should cover all types of activities generating market risks. Supervisors may also consider breakdowns o f positions at the level o f individual portfolios, including, in the case o f banks, trading and non-trading acti’ 'ties. 40. Supervisors will be interested in some or all o f the following: position data that would allow independent supervisory assessment o f market risk through the use o f some supervisory model or monitoring criteria and data derived from an institution's own internal estimates o f market risk. 41. For certain institutions, particularly those that are not major dealers, it may be appropriate to obtain position data (e.g. equities, debt securities, foreign exchange and commodities), which could be drawn from the framework o f the Basle Committee's standardised approach for market risk, once adopted, or from other approaches adopted by national banking and securities supervisors. The collection o f position data could be carried out at various levels o f detail, depending on the nature and scope o f the institution's trading and derivatives activities. The detail can range from a broad measure o f exposure at the portfolio level to a finer disaggregation by instrument and maturity. 42. As an alternative or supplement to assessing position data, supervisors could evaluate available information on an institution's internal estimates o f market risk. For some institutions, this information could be derived from their internal value-at-risk methodology, which involves the assessment o f potential losses due to adverse movements in market prices o f a specified probability over a defined period of time. As an alternative to value-at-risk, supervisors may find it useful on a case-by-case basis to assess internally-generated - 13 - information on eamings-at-risk,9 duration or gap analysis, scenario analyses, or any other approach that sheds light on an institution's market risk. W hatever the approach taken, supervisors should consider the measure o f market risk exposure in the context o f the institution's limit policies. 43.If a firm uses value-at-risk models for measuring market risks, the supervisor should evaluate in detail the methodology used, including its main parameters. Key parameters for evaluating value-at-risk estimates include: (1) the volatility and correlation assumptions o f the model (either implied or historical volatilities), (2) the holding period over which the change in portfolio value is measured (e.g., two weeks), (3) the confidence interval used to estimate exposure (e.g., 99% o f all outcomes) and (4) the historical sample period (e.g., one year or two years) over which risk factor prices are observed. 44. Value-at-risk measured solely at a point in time may not provide appropriate insights about market risk due to the speed with which positions in derivatives and other instruments can be altered. Such difficulties may be addressed by the use o f summary statistics for the period over which the institution is reporting. For example, supervisors could require institutions to communicate information on the highest value-at-risk number measured during the reporting period, together with monthly or quarterly averages o f valueat-risk exposures. By comparing end-of-period value-at-risk with these other measures, supervisors can better understand the volatility which has occurred in these measures during the period. Supervisors could also encourage or require institutions to convey comparisons of daily value-at-risk estimates with daily changes in actual portfolio value over a given period.10 Internal models should be validated by comparing past estimates o f risk with actual results and by assessing the models' major assumptions. 45. Institutions with significant trading books should subject their portfolios on a regular basis to stress tests using various assumptions and scenarios. These analyses o f the portfolio under "worst case" scenarios should preferably be performed on an institution-wide basis and should include an identification o f the major assumptions used. Quantitative information on the results o f stress scenarios, which could be specified by supervisors or institutions themselves, coupled with qualitative analyses o f the actions that management might take under particular scenarios, would be very useful for supervisory purposes. Examples of scenarios for interest rate risk include a parallel yield curve shift o f a determined amount, a steepening or flattening o f the yield curve, or a change o f correlation assumptions. 9 Under mark-to-market accounting, value-at-risk w ill equal eamings-at-risk because changes in value are reflected in earnings. If accrual accounting is applied to certain positions, value-at-risk and eamings-at-risk will differ because all changes in value are not reflected in earnings. 10 The report o f the Euro-currency Standing Committee, a discussion paper entitled. Public D isclosure o f M arket a n d C redit Risks by Financial Interm ediaries, issued in September 1994 (Fisher Report), discusses factors to consider in interpreting value-at-risk measures, among other topics. - 1446. To minimise burden, supervisory assessment o f market risks should draw as much as possible on the information that institutions must collect for supervisory capital purposes. In the case o f the banking sector, the Basle Committee's market risk capital requirements, once finalised and implemented, should serve as a basis for supervisory information on banks' market risks. In addition, bank supervisors should consider adopting some o f the definitions o f the market risk capital standards for reporting purposes, such as the definition o f the trading book. 4. Earnings 47. As with cash market instruments, the profitability o f derivatives activities and related on-balance-sheet positions are o f interest to supervisors. The separate effects on income o f trading activities and activities other than trading would also be o f interest. 48. Accounting standards and valuation techniques differ from country to country and many member supervisors have little or no legal authority in this area. The Committees therefore recognise that earnings information identified under this framework may not be fully comparable across member countries. (a) 49. Trading purposes Many sophisticated market participants view cash and derivative instruments as ready substitutes; their use o f derivatives is complementary to cash instruments and positions in financial instruments are often managed as a whole. For supervisors to consider information that concentrates solely on derivatives and to omit similar data on cash instruments could be misleading. In this context, the decomposition o f trading revenues (from cash and derivative instruments) according to broad risk classes - interest rate risk, foreign exchange risk, commodities and equities exposures, or other risks to the firm - without regard to the type o f instrument that produced the trading income, may better describe the outcome o f overall risk taking by the organisation. 50. The systems o f some banks or securities firms may not decompose trading revenues by broad categories o f risk. Under these circumstances, simplifying assumptions can be used to approximate this categorisation o f income. For example, if a particular department o f an institution typically handles domestic bonds and related derivatives, it may be appropriate to consider trading gains and losses on these instruments as interest related income. Further, the income from complex instruments that are exposed to both foreign exchange and interest rate risk could be classified according to the primary attribute o f the instrument (e.g., either as a foreign currency or an interest rate instrument). 51. Finer disaggregation o f trading revenue within risk categories, for example, by origination revenue, credit spread revenue and other trading revenue could be useful in - 15evaluating an organisation's performance relative to its risk profile.11 However, even those dealers with sophisticated information systems may not now be able to differentiate income beyond broad risk categories. As the analytical abilities and systems o f market participants evolve, it m ay be desirable to consider supervisory information that differentiates between revenue earned from meeting customer needs and that earned from other sources. Furthermore, as market participants' systems evolve, it may be desirable for supervisors to evaluate information that differentiates between trading revenue earned from cash and derivatives positions in each broad risk category. As with cash instruments, a rapid build-up o f material trading losses on derivative instruments may indicate deficiency in an institution's risk management systems and other internal controls that it should promptly evaluate and correct. (b) 52. Purposes other than trading Information about derivatives held for purposes other than trading (end-user derivatives holdings) can also be useful to supervisors. For example, quantitative information that includes the effect on reported earnings o f off-balance-sheet positions held by the organisation to manage interest rate and other risks would be useful. When combined with information on other factors affecting net interest margins and interest rate sensitivity, this could provide insight into whether derivatives were being used to reduce interest rate risk or to take positions inconsistent with this objective. (c) 53. Identifying unrealised or deferred losses As with cash instruments, any material build-up o f unrealised losses or losses that have been realised but deferred by the institution may be an area o f supervisory interest, particularly for banking supervisors. At a minimum, the detection of such losses, and particularly, an accumulation of such losses, should prompt supervisory inquiry. Derivative contracts with unrealised losses or deferred losses may reduce future earnings and capital positions when these losses are reflected in profits and losses for accounting purposes. Therefore, when unrealised losses or deferred amounts are material, it is important for supervisors to consider an institution's plans for reflecting these losses in their reported profits and losses for accounting purposes. Moreover, a rapid build-up of material unrealised or deferred losses may indicate a deficiency in an institution's internal controls and accounting systems that it should promptly evaluate or correct. 11 As industry participants have recognised, trading revenue components may include: (1) origination revenue that results from the initial calculation o f the market value o f new transactions; (2) credit spread revenue that results from changes during the period in the unearned credit spread; and (3) other trading revenues resulting from changes in the value o f the portfolio due to market movements and the passage o f time. - 16- (d) 54. Derivatives valuation reserves and actual credit losses Supervisors should assess information on the valuation reserves that an institution has established for its derivatives activities and on any credit losses on derivative instruments that the institution has experienced during the period. In assessing these valuation reserves and any credit losses, it is important to understand the institution's risk management policies and valuation practices regarding derivatives. In addition, supervisors should determine how the institution reflected valuation reserves and credit losses in its balance sheet and income statement. Information on valuation reserves and the treatment o f credit losses is useful in understanding how adverse changes in derivatives risks can affect an institution's financial condition and earnings. III. Common minimum information framework (a) 55. Overview The two Committees recommend that member supervisors have available to them a minimum subset o f the catalogue o f data items listed in the above section for large internationally active banks and securities firms with significant derivatives activities. This common minimum framework is presented in Annex 3 and focuses primarily on information relating to credit risk, market liquidity risk and overall market activity. Annex 4 provides common definitions for the concepts used in the common minimum reporting framework. 56. The common minimum framework represents a baseline o f information that the Committees have identified as important for supervisors to begin assessing the nature anc. scope o f an institution's derivatives activities and how derivatives contribute to an institution's overall risk profile. Based on considerations such as an institution's size and business activities, supervisors may wish to supplement the information o f the common minimum framew'ork with other information drawn from the catalogue presented in the previous section. It is expected that supervisors would revisit the common minimum framework periodically to ensure that it is in line with activities o f banks and securities firms, market innovations and the state of supervisory reporting at the level o f individual member countries. For example, the common minimum framework presented in this paper currently does not focus on market risk. However, in the case o f banks, supervisory capital standards for market risks, once finalised, could serve as a basis for assessing comparable information on these risks. 57. The development o f a common minimum framework o f information could also support the efforts of the Euro-currency Standing Committee o f G-10 central banks to collect, on a regular basis, aggregate market data on the derivatives activities of financial institutions. Compilation and disclosure o f aggregate market data on derivatives activities could serve a useful supervisor)' function. For example, disclosure o f aggregate market data could give supervisors a better picture o f how concentrated an institution's activities are in a particular - 17 product. Such co-ordination o f data collection initiatives between banking and securities supervisors and central banks also could contribute to limiting the reporting burden for the banking and securities industries. (b) 58. Description o f minimum framework tables The elements of the common minimum framework are summarised in Tables 1 through 5 o f Annex 3. The tables are intended to illustrate the information under the minimum framework and do not reflect required reporting forms. 59. Table 1 provides information for understanding the scope and nature o f an institution's involvement in the derivatives markets. The table provides notional amounts by broad category o f risk (interest rate, exchange rate, precious metals, other commodities and equities) and by instrument type (forwards, swaps and options). The table also gives supervisors a picture o f whether the institution is primarily involved in OTC derivatives or exchange-traded contracts. Finally, the information helps supervisors understand whether derivatives are being used for trading purposes or for purposes other than trading such as hedging, which is particularly relevant for banking institutions. As indicated in footnote number 1, supervisors are also encouraged to obtain separate information on certain instruments, particularly on leveraged and other high-risk derivative instruments. 60. Table 2 summarises the minimum information for assessing the market values (gross positive and gross negative) by broad risk categories, including a distinction between contracts that are held for trading purposes and those held for purposes other than trading (generally, this distinction is of more relevance to banking supervisors). The information on market values provides supervisors with an alternative to notional amounts for gauging an institution's involvement in the derivatives markets. In addition, information on positive and negative market values enables supervisors to determine if an institution is a net creditor or borrower. Identifying market values for contracts other than trading can, in the case o f banks, shed light on an institution's risk management strategy and the extent to which it may be exposed to a significant build-up o f unrealised losses. Finally, in addition to market values, Table 2 illustrates that information on potential credit exposure by major category o f risk should be considered an element of the minimum framework. 61. Table 3 identifies information on the notional amounts of derivatives by broad category o f risk and by maturity (one year or less, over one year through five years, over five years.) Given the importance o f maturity information for assessing the risks of options, these are broken out in a separate line item for each o f the broad risk categories. 62. Table 4 focuses on counterparty credit risk taking into account the credit quality o f the counterparty'. The counterparty credit quality categories are sufficiently flexible to allow for the application o f the Basle Capital Accord risk-weighting framework for banks, as well as an approach based on either rating agency grades or on the equivalent internally generated ratings of an institution. The measurement o f counterparty credit exposure - 18incorporates the impact o f legally enforceable netting agreements as well as the use o f collateral and guarantees. Furthermore, the table provides extra information on the quality and value o f collateral and guarantees associated with derivative instruments. 63. Table 5 supplements the information on credit quality contained in Table 4 by focusing on instruments that are past-due by 30-89 days and by 90 days or more, and on actual credit losses. The information in the over 90 day category could also include information on derivatives that in the institution's assessment will not be fully collectible though they are currently performing. The table indicates the flexibility for supervisors to apply different maturity breakdowns if their national reporting systems do not use the time intervals presented in the minimum framework. In addition, information on the credit losses arising from derivatives activities is included as part o f the minimum framework. Framework for Supervisory Information on Derivatives Activities Use 1. C r e d it R is k ( O T C C o n t r a c t s ) (A ) C u r r e n t C r e d i t E x p o s u r e (B ) Description R isk o f lo s s (a ggregated acro ss all a c tiv itie s) due to counterparty default. T o th e ex ten t p o ssib le , credit risk from on - and o ff-b a la n ce -sh e et instrum ents sh o u ld be co n sid ered together. P o sitiv e R ep la cem en t C ost: 1. N etted to reflect le g a lly en fo rcea b le bilateral n ettin g a g reem en ts (a lso c o n sid er a v era g e and range o f v a lu es o v er reporting period). 2. G ross by typ e - interest rate, foreign e x c h a n g e , eq u ity , p recio u s m eta ls and other c o m m o d itie s. P o t e n t ia l C r e d i t E x p o s u r e D ata a llo w in g in d ep en d en t su p erv iso ry a sse ssm en t o f exp osu re. Data reflectin g in stitu tio n ’s a sse ssm e n t u sin g internal m o d els. G ross N o tio n a ls 1. 2. B y ty p e - interest rate, foreign ex c h a n g e , eq u ity , p recio u s m eta ls and oth er co m m o d itie s. M aturity - o n e year or le ss, o v er o n e year through fiv e years, o v e r fiv e years. Internally generated estim a tes o f potential credit risk ca lcu la ted b y counterparty and su m m ed . U tilise m o d el sp e cific a tio n s and param eters that are eith er d esign ated b y the su p erv iso r or currently e m p lo y e d by the individual in stitu tion s in the risk m an agem en t p ro cess. (C ) C r e d it E n h a n c e m e n t s C ollateral - H ow m u ch o f cred it e x p o su re is M arket v a lu e o f collateral h eld again st netted current and poten tial exp osu re. collateralised ? C ollateral A g reem en ts - H o w m u ch o f p oten tial exp osu re is su b ject to colla tera l agreem en ts? (D ) C o n c e n t r a t io n s o f C r e d i t N o tio n a l am ount and m arket valu e o f contracts w ith agreem en ts to p ro v id e a d d itio n a l collateral sh o u ld credit ex p o su re increase. N u m b er o f counterparties w ith current and p oten tial cred it e x p o su res greater than a sp e c ifie d m in im u m le v e l o f the reporter's capital. T otal ex p o su re to th ese counterparties (p o sitiv e n et rep lacem en t c o st and potential credit ex p o su re). C ounterparty credit e x p o su re is better ev alu ated b y tak in g in to con sid eration both ca sh -in stru m en t and o ff-b a la n ce -sh e e t relation sh ip s. S u p ervisors m a y a ls o w ish to obtain inform ation on an institution's a g gregate e x p o su res to v ariou s e x c h a n g e s and on their ex p o su r e s to certain ty p es o f collateral. C o u n t e r p a r t y C r e d i t Q u a l it y T otal p o sitiv e net rep lacem en t c o st and p otential credit ex p o su re b y cou nterparty cred it q u ality (b y B a sle C apital A ccord r isk -w eig h ts, by rating a g en cy grad es, or b y internal ratings). Inform ation on p ast-d u e status and actual cred it lo s se s, b y m ajor cou n terp arties and in the aggregate. Annex 1 (E ) Framework for Supervisory Information on Derivatives Activities Use II. L iq u id it y R is k Description ------------------- :----------------------------------------------------- ----------------------------- -rM arket liq u id ity risk - risk that p o sitio n can n ot be liquid ated or h ed ged . ----— —----------------------- ------ j F unding risk - in su fficien t c a sh -flo w or liq u id a ssets to m eet c a sh -flo w req u irem en ts. (In addition to inform ation b e lo w , inform ation about the notion al am ou n ts and ex p e c te d cash flo w s o f d eriv a tiv es acco rd in g to sp e c ifie d tim e in tervals.) (A ) I d e n t if y p o t e n t i a l m a r k e t l iq u i d i t y e x p o s u r e s . N o tio n a l am ou n ts and m arket v a lu es for ex ch an ge-trad ed and O T C d e r iv a tiv es b y m arket and product type: - OTC • Interest Rate - forw ards, sw a p s, am o rtisin g sw a p s, o p tio n prod ucts • F oreign E xch an ge - forw ards, sw a p s, op tion p rodu cts • • - E q u ities C o m m o d itie s and other E xch an ge-T rad ed Futures and O p tio n s • Interest rate • F oreign exch a n g e • Equity • C o m m o d ity and other N o tio n a l am ou n ts and e x p ec te d cash in and o u tflo w s b y m aturities. (B ) I d e n t if y O T C c o n t r a c t s w it h t r ig g e r i n g p r o v is io n s . N o tio n a ls and p o sitiv e and n eg a tiv e m arket v a lu e o f con tracts w ith triggerin g p r o v isio n s (th is in form ation co m b in ed g iv e s a picture o f the n et flo w s, in and out, resu ltin g from con tracts w ith triggers): that require the institution to liq u id ate or p ost collateral in the w a k e o f ad v erse e v e n ts a ffe c tin g it; that the institution can require its counterparty to liquid ate or p o st co lla tera l in the w a k e o f ad verse e v en ts a ffe ctin g that counterparty. (C ) M a r k e t a c t iv it y N o tio n a l am ounts and g r o ss p o sitiv e and g r o ss n e g a tiv e m arket v a lu e o f d e r iv a tiv es b y risk c a teg o ry and contract typ e. T h is data co u ld b e agg reg a ted a cro ss in stitu tion s to p ro v id e in form ation on total m arket size. Framework for Supervisory Information on Derivatives Activities Use III. M a r k e t R is k Description Risk o f loss from adverse changes in market prices - data w ill need to be collected separately for trading and non trading portfolios. Data could be collected by broad risk category (i.e., interest rate, foreign exchange, equities, com m odities, etc.). Market risk best assessed from a portfolio context. Position data allow ing independent supervisory assessm ent using sim plified approaches. For example: - - Net open positions (longs minus shorts) by risk category (interest rate, foreign exchange, equities, com m odities). For equity contracts, net open positions by individual issues. For interest rate and com m odities contracts, net open positions by maturities. Duration information on interest rate positions. Options could be included on a delta-equivalent basis. Other data for alternative supervisory m odels or screening criteria. Data on institution's internal assessm ent o f market risk. Internally generated estimate o f market risk through a value-at-risk (V A R ) m ethodology, eam ings-at-risk, duration or gap analysis, or som e other methodology. For information on V AR , can use m odel specifications and parameters that are either designated by supervisors or currently em ployed by individual institutions in the risk management process. These include: 1. 2. 3. 4. 5. Position sensitivities Market risk factor volatilities Market risk factor correlations Historical sample period and holding period Confidence interval Information on the average and range o f VAR estimates over the reporting period more informative than point in time estimates. Internal model validation information: 1. 2. Results o f stress tests. The stress test could be specified by supervisors, the institution itself, or by a combination o f both. Comparisons o f estimated risk vs. actual results - back-testing Major assumptions underlying m odels A nalysis o f likelihood o f "worst case" scenarios preferably on an institution-wide basis. Identification o f major assumptions. Qualitative analysis o f actions management might take under particular scenarios. Framework for Supervisory Information on Derivatives Activities Use IV . Description E a r n in g s (A) T rad in g purposes Revenues from trading activities (derivatives and cash instruments) by risk type (interest rate, foreign exchange, equities, com m odities and other) or by major trading desks (bonds, swaps, FX, equities, etc). (B) P urposes oth er than trading Impact on net income: net increase (decrease) in interest incom e, net increase (decrease) in interest expense and other (non-interest allocations). ((-) Identify u n realised or d eferred losses Notional amounts, market values and unrealised losses o f derivatives held on an accrual basis. Amount o f realised losses on derivatives that have been deferred. Could be collected either by instrument or in total. (0 ) D erivatives v a lu ation reserves and actual credit losses Amount o f valuation reserves or provisions and actual credit losses, and their earnings impact. Derivatives data elements and their uses E le m e n t 1. U se Gross or Effective Notionals: OTC by Contract Type Exchange-Traded by Contract Type Position (Long and Short) Credit and Liquidity Risks Credit and Liquidity Risks Market Risk 2. Positive Net Replacem ent Cost Credit Risk 3. Gross Positive M arket Value by Broad Risk Category Market Activity, Credit Risk and Liquidity Risk 4. Gross Negative M arket Value by Broad Risk Category Market Activity and Liquidity Risk 5. Collateral Credit Risk (Current and Potential Credit Exposure) 6. Contracts with Collateral Agreements Potential Credit Exposure and Liquidity Risk 7. Counterparty Exposures Identified by Risk W eight or Investment Rating (Positive Net Replacement Cost and Potential Credit Exposure) Credit Risk (Counterparty Credit Quality) 8. Notional Am ounts for Broad Risk Categories o f Derivatives by Maturities. 9. Internal Estimate o f Potential Credit Exposure 10. Counterparties with Significant Netted Credit Exposure Potential Credit Exposure, M arket Risk, Liquidity Risk Credit Risk (Potential Exposure) Concentration o f Credit Risk Derivatives data elements and their uses E le m e n t U se 1 1. Contracts with Trigging Provisions Liquidity Risk 12. Market Value o f Contracts Held for Other than Trading Earnings 13. Internal "Valuc-at-Risk" Estimates by Broad Risk Categories (Including Interest Rates, Foreign Exchange Rates, Commodity and Equity Prices) Market Risk 14. Position Data (Longs and Shorts) for Debt Securities, Equities, Foreign Exchange and Commodities Market Risk 15. Trading Revenues (Cash and Derivative Instruments) by Risk Type (Includes Interest Rate, Foreign Exchange, Equity, Commodity, etc.) Earnings 16. Impact on Net Income (Net Interest Income, Net Interest Expense and Other Non-interest Allocations) o f Derivatives Held for Purposes Other Than Trading Earnings 17. Unrealised and Deferred Losses Earnings 18. Valuation Reserves and Credit Losses Earnings, Credit Risk Common minimum information framework T ab le 1: N otional am ounts by un d erlyin g exposures N o tio n a l a m o u n ts* In te r e st rate c o n tr a c ts F o re ig n e x c h a n g e a n d g o ld c o n tr a c ts * P r e c io u s m e ta ls (o th e r th a n g o ld ) c o n tr a c ts O th e r c o m m o d ity c o n tr a c ts E q u ity -lin k e d c o n tr a c ts O T C c o n tr a c ts Forwards Swaps Purchased options Written options E x c h a n g e -tr a d e d c o n tr a c ts Futures - long positions Futures - short positions Purchased options Written options T o ta l c o n tr a c ts h eld fo r tr a d in g ^ T o ta l c o n tr a c ts h eld fo r o th e r th a n tr a d in g 1. While included in this table's aggregate information, supervisors may wish to obtain separate information on certain categories o f higher risk derivative instruments, as appropriate. 2. This does not include spot foreign exchange, which may be assessed as a separate item. W hile included in the aggregate information in this colum n, for securities firms, information on the notional amounts o f gold contracts should be evaluated separately. 3. For purposes o f these totals, all derivative instruments o f securities firms w ill be considered to be in the "contracts held for trading" category. Common minimum information framework T abic 2: O T C N otional am ounts, m arket values and potential cred it exposure T o ta l n o tio n a ls, m a r k e t v a lu e s and p o te n tia l c r e d it e x p o su re * In te r e st rate c o n tr a c ts F o re ig n e x c h a n g e a n d gold P r e c io u s m e ta ls (o th e r th a n g o ld ) c o n tr a c ts ^ c o n tr a c ts O th e r c o m m o d ity c o n tr a c ts E q u ity -lin k e d c o n tr a c ts T o ta l n o tio n a l am ounts-* C o n tr a c ts h eld for tr a d in g p u rp o se s^ (a) Gross positive market value (b) Gross negative market value C o n tr a c ts h eld for o th e r th a n tr a d in g (a) Gross positive market value (b) Gross negative market value P o ten tia l c red it ex p o su re ^ 1. W hile included in this table’s aggregate information, supervisors may wish to obtain separate information on certain categories o f higher risk derivative instruments, as appropriate. 2. This does not include spot foreign exchange, which may be assessed as a separate item. W hile included in the aggregate information in this colum n, for securities firms, information on the notional amount, market value and potential future exposure o f gold contracts should be evaluated separately. 3. The "total notional amounts” reflected on this line are the sum o f the notional amounts o f the OTC contracts summarised in Table 1. 4. For purposes o f these totals, all derivative instruments o f securities firms w ill be considered to be in the "contracts held for trading" category. 5. For banks, information on potential credit exposure should be in accordance with the Basle Capital Accord. Securities firms should use approaches acceptable to their regulator in estimating these amounts. Common minimum information framework T ab le 3: O T C derivative con tracts’ notional am ounts by tim e intervals O T C C o n tr a c ts 1 O n e y e a r o r less O v e r o n e y e a r th r o u g h O v e r Five y e a r s fiv e y e a r s (a) Interest rate contracts Purchased options (b) Foreign exchange and gold contracts^ Purchased options (c) Precious mclals (other than gold) contracts Purchased options (d) Other com m odity contracts Purchased options (e) Equity-linked contracts Purchased options 1. W hile included in this table's aggregate information, supervisors may wish to obtain separate information on certain categories o f higher risk derivative instruments, as appropriate. 2. This does not include spot foreign exchange, which may be assessed as a separate item. W hile included in the aggregate information in this colum n, for securities firms, information on the notional amounts (by time intervals) o f gold contracts should be evaluated separately. Note: The information in this table is based on the remaining maturity o f the derivative instrument. Supervisors broad risk categories noted above) based on the maturity o f the underlying. may also want to evaluate information about options (by the Common minimum information framework T ab le 4: Inform ation on credit quality o f O T C derivative con tracts E x p o su r e b e fo r e c o lla te r a l a n d g u a r a n te e s C o u n te r p a r ty c r e d it q u a lity * C r e d it e q u iv a le n t a m o u n t a fte r C r o s s p o s itiv e m a r k e t v a lu e C u r r e n t c r e d it e x p o su r e P o te n tia l c r e d it e x p o su r e C r e d it q u a lity * C o lla te r a l G u a r a n te e s c o lla te r a l a n d g u a r a n te e s 1 2 3 Total 1 2 3 * C r ed it q u a lity c a te g o r ie s w o u ld b e d e fin e d a s fo llo w s 1. For banks, category 1 identifies counterparties given a 0% risk weight under the Basle Capital Accord. For securities firms, category 1 identifies counterparties rated A A and above. 2. For banks, category 2 identifies counterparties given a 20% risk weight under the Basle Capital For securities firms, category 2 identifies counterparties rated BBB and above. 3. For banks, category 3 identifies counterparties given a 50% risk weight under the Basle Capital Accord. For securities firms, category 3 identifies counterparties rated below BBB. Accord. Note: When basing the above categories on ratings, an institution's equivalent internal credit grade ranking may be used when investment ratings are not available. M oreover, in addition to using the credit quality categories based on Basle Accord risk w eights, bank supervisors may w ish to assess the above information by credit ratings assigned by external rating agencies or by an institution's internal credit grade rankings. Common minimum information framework Table 5: Information about past-due OTC derivatives and credit losses^ B o o k v a lu e o f d e r iv a t iv e s p a s t -d u e 3 0 - 8 9 d a y s B o o k v a lu e o f d e r iv a t iv e s p a s t -d u e 9 0 d a y s o r m o r e 2 G r o s s p o s i t iv e m a rk et v a lu e o f d e r iv a t iv e s p a st d u e 3 0 - 8 9 d a y s G r o s s p o s i t iv e m a r k et v a lu e o f d e r iv a t iv e s p a s t -d u e 9 0 d a y s o r m o r e 2 C red it lo s s e s o n d e r iv a t iv e in s tr u m e n ts d u r in g th e p e r io d 1. Certain countries may apply different maturity breakdowns when assessing past-due derivatives. Also, supervisors may wish to consider information on derivatives that have been restructured due to deterioration in counterparty credit quality or past-due status, together with information on collateral and guarantees supporting these exposures. W hile included in this table's aggregate information, supervisors may wish to obtain separate information on certain categories o f higher risk derivative instruments, as appropriate. 2. Information about derivatives that are past due 90 or more should also include information about derivatives that, w hile not technically past-due, are with counterparties that are not expected to pay the full amounts ow ed to the institution under the derivative contracts. Annex 4 Definitions for elements o f the common minim um inform ation fram ework I. Introduction This set o f definitions refers to items identified in the common minimum information framework for derivative instruments. These definitions are intended to assist supervisors when analysing information about institutions' derivatives activities by improving the consistency and comparability o f this information. The information presented below is intended as supplemental guidance to the notes in Tables 1 - 5 o f the comm on minimum information framework. II. General concepts (a) Broad risk categories (Tables 1 - 3 ) For supervisory analysis purposes, five broad risk categories for derivative contracts are used in the common m inimum information framework. Derivative contracts with multiple risk characteristics should be categorised based on the predominant risk characteristics at the origination o f the contract. These five broad risk categories are summarised below. 1. Interest rate contracts. Interest rate contracts are contracts related to an interest-beai.ng financial instrument or whose cash flows are determined by referencing interest rates or another interest rate contract (e.g. an option on a futures contract to purchase a domestic government bond). These contracts are generally used to adjust the institution's interest rate exposure or, if the institution is an intermediary, the interest rate exposure o f others. Interest rate contracts include single currency interest rate swaps, basis swaps, forward rate agreements, futures contracts committing the institution to purchase or sell financial instruments and whose predominant risk characteristic is interest rate risk and interest rate options, including caps, floors, collars and corridors. Excluded are contracts involving the exchange o f one or more foreign currencies (e.g. cross currency swaps and currency options) and other contracts whose predominant risk characteristic is foreign exchange risk, which should be evaluated as foreign exchange contracts. Excluded are commitments to purchase and sell when-issued securities from interest rate contracts. Supervisors may wish to evaluate these separately. 2. Foreign exchange contracts: Foreign exchange contracts are contracts to purchase foreign currencies or contracts whose cash flows are determined by reference to foreign currencies. Foreign currency contracts include forward foreign exchange, currency -2futures, currency options, currency warrants and currency swaps. Such contracts are usually used to adjust an institution's foreign currency exposure or, if the institution is an intermediary, the foreign exchange exposure o f others. Spot foreign exchange contracts can be excluded from this definition, as they are not derivative instruments. All amounts reflected as foreign exchange contracts should be translated into the institution's base (or functional) currency. For the purpose o f supervisory analysis, only one side o f a foreign currency transaction should be reported. In those transactions where foreign currencies are bought or sold against an institution's base currency, include only that side o f the transaction which involves the foreign currency. For example, if a US institution with a base currency of US dollars enters into a futures contract in which it purchases US dollars against Deutsche marks, then the amount o f Deutsche marks sold would be reflected as a foreign exchange contract (in US dollar equivalent values). Consistent with this approach, in cross-currency transactions, which involve the purchase and sale o f two foreign currencies, only the purchase side should be reflected in the information about foreign exchange contracts. For purposes o f this analysis, bank supervisors should evaluate gold contracts together with foreign exchange contracts. Supervisors o f banks and securities firms may also wish to evaluate information about gold contracts separately. 3. Precious metals (other than gold) contracts: All contracts that have a return, or portion o f their return, linked to the price of silver, platinum and palladium contracts or to an index of precious metals other than gold should be reflected in this broad risk category. 4. Other commodity contracts: Other commodity contracts are contracts that have a return, or a portion o f their return, linked to the price o f or to an index o f a commodity such as petroleum, lumber, agricultural products, or to non-ferrous metals such as copper or zinc. Other commodity contracts also include any other contracts that are not appropriately categorised as interest rate, foreign exchange and gold, other precious metals or equity derivative contracts. 5. Equity-linked contracts'. Equity-linked derivative contracts are contracts that have a return, or a portion o f their return, linked to the price o f a particular equity or to an index o f equity prices, such as the Standard and Poor's 500 or the Nikkei. B. 1. Purposes for holding derivative instruments (Tables 1-2) Contracts held fo r trading purposes: Contracts held for trading purposes include those used in dealing and other trading activities accounted for at market value (or at lower of cost or market value) with gains and losses recognised in earnings. Derivative -3- instruments used to hedge trading activities should also be reflected as derivatives held for trading purposes. Derivative trading activities include (a) regularly dealing in interest rate contracts, foreign exchange contracts, equity derivative contracts and other off-balance-sheet commodity contracts; (b) acquiring or taking positions in such items principally for the purpose o f selling in the near term or otherwise with the intent to resell (or repurchase) in order to profit from short-term price movements; or (c) acquiring or taking positions in such items as an accommodation to customers. 2. Contracts held f o r other than trading purposes: Derivative contracts that are held for purposes other than trading include (a) off-balance-sheet contracts used to hedge debt and equity securities not in the institution's trading accounts; (b) foreign exchange contracts that are designated as, and are effective as, economic hedges o f items not in trading accounts; and (c) other off-balance-sheet contracts used to hedge other assets or liabilities not held for trading purposes. Included in this information are the notional amount or par value o f contracts such as swap contracts intended to hedge interest rate risk on commercial loans that are accounted for on a historical cost basis. (c) 1. Notional amounts (Tables 1 - 3 ) General concepts: Notional amounts reflect the gross par value (e.g. for futures, forwards and option contracts) or the notional amount (e.g. for forward rate agreements and swaps), as appropriate, for all off-balance-sheet contracts. These contracts should be evaluated under the broad risk categories summarised in II.(a). Furthermore, these notional amounts should be stated in local currency. For purposes o f the common minimum information framework, the notional amount or par value for an off-balance-sheet derivative contract with a multiplier component is the contract's effective notional amount or par value. For example, a swap contract with a stated notional amount o f $1,000,000 whose terms called for quarterly settlement o f the difference between 5% and LIBOR multiplied by 10 has an effective notional amount o f $10,000,000. 2. Special considerations fo r gold contracts, precious metals (other than gold) contracts and other commodity contracts: The contract amount for commodity and other contracts should be the quantity, e.g. number o f units, o f the commodity or product contracted for purchase or sale multiplied by the contract price o f a unit. The notional amount for a commodity contract with multiple exchanges o f principal is the contractual amount multiplied by the number o f remaining payments (or exchanges o f principal ) in the contract. -4 3. Special considerations f o r equity-linked contracts: The contract amount for equity derivative contracts is the quantity, e.g. number o f units, o f the equity instrument or equity index contracted for purchase or sale multiplied by the contract price o f a unit. 4. Notional amounts o f OTC derivatives by tim e intervals (Table 3): Table 3 summarises the notional amounts or par value o f OTC off-balance-sheet contracts included in Tables 1 and 2 that are subject to credit risk. (For banks, these OTC contracts are subject to risk-based capital requirements.) Such contracts include swaps, forwards and OTC purchased options. The notional amounts and par values should be presented in the column corresponding to the contract's remaining term to maturity from the evaluation date. For supervisory analysis purposes, the remaining maturities are (1) one year or less; (2) over one year through five years; and (3) over five years. Supervisors may also want to evaluate information about purchased options based on the maturity o f the underlying. This information on notional amounts should not reflect the notional amount for single currency interest rate swaps in which payments are made based upon two floating rate indices, so-called floating/floating or basis swaps; foreign exchange contracts with an original maturity o f fourteen days or less; and futures contracts. The notional amount for an amortising off-balance-sheet derivative contract is the contract's current (or, if appropriate, effective) notional amount. This notional amount should be reflected in the column corresponding to the contract's remaining term to final maturity. (d) Gross positive and negative market values (Tables 2 ,3 and 5 present information on gross positive market values; Table 2 presents information on gross negative market values) 1. The market value o f an off-balance-sheet derivative contract is the amount at which a contract could be exchange in a current transaction between willing parties, other than in a forced or liquidation sale. If a quoted market price is available for a contract, the market value for that contract is the product o f the number o f trading units o f the contract multiplied by that market price. If a quoted market price is not available, the institution's best estimate o f market value could be used, based on the quoted market price o f a similar contract or on valuation techniques such as discounted cash flows. Market values should be reflected in the local currency o f the institution. 2. Gross positive market values represent the loss that an institution would incur in the event of a counterparty default, as measured by the cost of replacing the contract at current market rates or prices. (This measure does not reflect reductions in credit exposure that would occur under legally enforceable netting arrangements.) (e) Current credit exposure (Table 4) Current credit exposure (sometimes referred to as the replacement cost) is the market value o f a contract when that value is positive. Current credit exposure amounts for OTC off-balance-sheet derivative contracts reflect consideration o f the effects o f applicable legally enforceable bilateral netting agreements. For banks, current credit exposure amounts should be consistent with the risk-based capital standards. The current credit exposure is zero when the market value is negative or zero. Current credit exposure should be derived as follows: determine whether a legally enforceable bilateral netting agreement is in place between the institution and a counterparty. If such an agreement is in place, the market values o f all applicable contracts with that counterparty that are included in the netting agreement are netted to a single amount. Next, for all other contracts covered by the risk-based capital standards that have positive market values, the total o f the positive market values is determined. Then, current credit exposure is the sum o f (i) the net positive market values of applicable contracts subject to legally enforceable bilateral netting agreements and (ii) the total positive market values o f all other contracts covered by the risk-based capital standards. The definition o f a legally enforceable bilateral netting agreement for purposes o f this item is the same as that set forth in the risk-based capital rules. (f) Information on credit quality o f OTC derivative contracts (Table 4) Gross positive market value and current credit exposure have been defined in 11(d) and 11(e) above. Potential credit exposure is the exposure o f the derivative contract that may be realised over its remaining life due to movements in the rates or prices underlying the contract. For banks, under the Basle Capital Accord, potential credit exposure is reflected through a so-called "add-on", which is calculated by multiplying the contract's gross or effective notional value by a conversion factor based on the price volatility of the underlying contract. There are separate factors for interest rate contracts, foreign exchange and gold contracts, precious metals (other than gold) contracts, other commodities contracts and equity-linked contracts - distinguishing between the remaining maturity o f the contract (i.e. one year or less, over one year to five years and more than five years). The add-ons may also take account o f the effects of legally valid netting agreements. For banks, information on potential credit exposure should be consistent with bank supervisory guidelines, including risk-based capital standards. -6Securities firms should use approaches acceptable to their regulators in estimating potential credit exposure. 3. For banks, information on the manner in which collateral and guarantees reduce current and potential credit exposure should be consistent with the Basle Capital Accord. For securities firms, information on the effects o f collateral and guarantees should reflect approaches that are acceptable to their regulators. (g) 1. Information about past-due derivatives (Table 5) The "book value" o f past-due derivatives is the amounts, if any, that are recorded as assets by the institution in its balance sheet. These amounts may include amounts accrued as receivable for interest rate swaps, the unamortised amount o f the premium paid for an interest rate cap or floor, or the market value o f a derivative contract in a gain position that has been recorded as an asset (e.g. in a trading account) on the balance sheet. 2. The "gross positive market value" o f past-due derivatives is consistent with the definition o f "gross positive market value" presented above (11(d)). These gross positive market values should be evaluated regardless o f whether they have been recorded as assets on the balance sheet. This information should not include the market value of derivative instruments with negative market values. 3. Credit losses include declines in positive market values for derivatives that are associated with deteriorating counterparty credit quality, when the mark to market values o f these derivatives have been recorded on the balance sheet. Credit losses may also include write-offs o f the book value o f derivatives - taking these write-offs against provisions (allowances) for credit losses. III. Definitions of specific types of derivatives (a) 1. Futures contracts Futures contracts represent agreements for delayed delivery o f financial instruments or commodities in which the buyer agrees to purchase and the seller agrees to deliver, at a specified future date, a specified instrument at a specified price or yield. Futures contracts are standardised and are traded on organised exchanges where the exchange or a clearing house acts as the counterparty to each contract. (b) 1. Forward contracts Forward contracts represent agreements for delayed delivery o f financial instruments or commodities in which the buyer agrees to purchase and the seller agrees to deliver, at a specified future date, a specified instrument or commodity at a specified price or yield. -7Forward contracts are not traded on organised exchanges and their contractual terms are not standardised. (c) 1. Option contracts Option contracts convey either the right or the obligation, depending upon whether the institution is the purchaser or the writer, respectively, to buy or sell a financial instrument or commodity at a specified price on or before a specified future date. Some options are traded on organised exchanges. Also, options can be written to meet the specialised needs o f the counterparty to the transaction. These customised option contracts are known as over-the-counter (OTC) options. Thus, over-the-counter option contracts include all option contracts not traded on an organised exchange. 2. The buyer o f an option contract has, for compensation (such as a fee or premium), acquired the right (or option) to sell to, or purchase from, another party some financial instrument or commodity at a stated price on or before a specified future date. The seller o f the contract has, for such compensation, become obligated to purchase or sell the financial instrument or commodity at the option o f the buyer o f the contract. A put option contract obligates the seller o f the contract to purchase some financial instrument or commodity at the option o f the buyer o f the contract. A call option contract obligates the seller o f the contract to sell some financial instrument or commodity at the option of the buyer o f the contract. 3. In addition, swaptions, i.e. OTC options to enter into a swap contact, and OTC contracts known as caps, floors, collars and corridors should be reflected as options for supervisory analysis purposes. 4. Generally, options such as a call feature that are embedded in loans, securities and other on-balance-sheet assets and commitments to lend art. not included in the supervisory analysis reflected in Tables 1 - 5 . Supervisors may wish to evaluate these embedded options separately in certain situations. 5. Purchased options: When assessing information on purchased options in Table 1, this information should reflect the aggregate notional or par value of the financial instruments or commodities that the institution has, for a fee or premium, purchased the right to either purchase or sell under exchange-traded or OTC option contracts that are outstanding as of the evaluation date. Also, include in OTC purchased options an aggregate notional amount for purchased caps, floors and swaptions and for the puf vnased portion of collars and corridors. 6. Written options: When evaluating information on written options for Table 1, this information should reflect the aggregate notional or par value of the financial -8 instruments or commodities that the institution has, for compensation (such as a fee or premium), obligated itself to either purchase or sell under exchange-traded or OTC option contracts that are outstanding as o f the evaluation date. Also reflect as written options the aggregate notional amount for written caps, floors and swaptions and for the written portion o f collars and corridors. (d) 1. Swaps Swaps are OTC transactions in which two parties agree to exchange payment streams based on a specified notional amount for a specified period. Forward starting swap contracts should be evaluated as swaps. The notional amount o f a swap is the underlying principal amount upon which the exchange o f interest, foreign exchange or other income or expense is based. The notional amount for a swap contract with a multiplier component is the contract's effective notional amount. In those cases where the institution is acting as an intermediary, both sides o f the transaction should be reflected in the information in Table 1.