'Wrong-way risk' means the risk arising from exposure to a counterparty or issuer when the collateral provided by that counterparty or issued by that issuer is highly correlated with its credit risk (Article 1(11) of Commission Delegated Regulation No 153/2013 of 19 December 2012 supplementing Regulation (EU) No 648/2012 of the European Parliament and of the Council with regard to regulatory technical standards on requirements for central counterparties).
The wrong-way risk is mitigated by regulatory technical standards (RTS) under EMIR:
"Two requirements are necessary on top of the other provisions on the collateral eligible for the exchange of margins: measures preventing wrong-way risk on the collateral and concentration limits. The RTS do not allow own-issued securities to be eligible collateral, except on sovereign debt securities. However, this requirement extends to corporate bonds, covered bonds, other debt securities issued by institutions and securitisations. These requirements will reduce concentration risk in the collateral placed in margins and are considered necessary to fulfil the requirement to have sufficient high-quality collateral available following the default of a counterparty" (Joint Committee of European Supervisory Authorities (ESAs): the European Banking Authority (EBA), the European Insurance and Occupational Pensions Authority (EIOPA) and the European Securities and Markets Authority (ESMA) Final Draft Regulatory Technical Standards of 8 March 2016 on risk-mitigation techniques for OTC-derivative contracts not cleared by a CCP under Article 11(15) of Regulation (EU) No 648/2012 (ESAs 2016 23), p. 10).
Consultative Report of Committee on Payments and Market Infrastructures, Board of the International Organization of Securities Commissions, Resilience and recovery of central counterparties (CCPs): Further guidance on the PFMI, August 2016 (p. p. 41, 42) makes distinction between general wrong-way risk and specific wrong-way risk (SWWR).
General wrong-way risk arises at a CCP when the potential losses of either a participant's portfolio or a participant's collateral is correlated with the default probability of that participant.
Examples of general wrong-way risk include situations where the equity or debt securities issued by one participant could lose significant value if another similar participant defaults to the CCP, or when a sovereign default could be strongly correlated with the default probability of a participant domiciled in the same
The said Report, moreover, adds that CCP should ensure that the risks addressed by its margin system explicitly include specific wrong-way risk (SWWR).
Principles for Financial Market Infrastructures (PFMI) define specific wrong-way risk as a risk that arises where an exposure to a counterparty is highly likely to increase when the creditworthiness of that counterparty is deteriorating.
As a general matter, the PFMI provide that a CCP should identify and mitigate any credit exposure that may give rise to SWWR, as well as review its portfolio regularly in order to identify, monitor and mitigate promptly any exposures that give rise to SWWR.
The challenge of identifying and seeking to address SWWR varies depending on the particular exposures a CCP may encounter in its clearing activities.
As a general matter, a CCP should have clear rules, policies and procedures in place to identify assess and mitigate SWWR.
Regulation (EU) No 575/2013 of the European Parliament and of the Council of 26 June 2013 on prudential requirements for credit institutions and investment firms and amending Regulation (EU) No 648/2012
1. For the purposes of this Article:
(a) "General Wrong-Way risk" arises when the likelihood of default by counterparties is positively correlated with general market risk factors;
(b) "Specific Wrong-Way risk" arises when future exposure to a specific counterparty is positively correlated with the coun terparty's PD due to the nature of the transactions with the counterparty. An institution shall be considered to be exposed to Specific Wrong-Way risk if the future exposure to a specific counterparty is expected to be high when the counterparty's probability of a default is also high.
2. An institution shall give due consideration to exposures that give rise to a significant degree of Specific and General Wrong-Way risk.
3. In order to identify General Wrong-Way risk, an institution shall design stress testing and scenario analyses to stress risk factors that are adversely related to counterparty credit worthiness. Such testing shall address the possibility of severe shocks occurring when relationships between risk factors have changed. An institution shall monitor General Wrong Way risk by product, by region, by industry, or by other categories that are relevant to the business.
4. An institution shall maintain procedures to identify, monitor and control cases of Specific Wrong-Way risk for each legal entity, beginning at the inception of a transaction and continuing through the life of the transaction.
5. Institutions shall calculate the own funds requirements for CCR in relation to transactions where Specific Wrong-Way risk has been identified and where there exists a legal connection between the counterparty and the issuer of the underlying of the OTC derivative or the underlying of the transactions referred to in points (b), (c) and (d) of Article 273(2)), in accordance with the following principles:
(a) the instruments where Specific Wrong-Way risk exists shall not be included in the same netting set as other transactions with the counterparty, and shall each be treated as a separate netting set;
(b) within any such separate netting set, for single-name credit default swaps the exposure value equals the full expected loss in the value of the remaining fair value of the under lying instruments based on the assumption that the under lying issuer is in liquidation;
(c) LGD for an institution using the approach set out in Chapter 3 shall be 100 % for such swap transactions;
(d) for an institution using the approach set out in Chapter 2, the applicable risk weight shall be that of an unsecured transaction;
(e) for all other transactions referencing a single name in any such separate netting set, the calculation of the exposure value shall be consistent with the assumption of a jump-to- default of those underlying obligations where the issuer is legally connected with the counterparty. For transactions referencing a basket of names or index, the jump-to-default of the respective underlying obligations where the issuer is legally connected with the counterparty, shall be applied, if material;
(f) to the extent that this uses existing market risk calculations for own funds requirements for incremental default and migration risk as set out in Title IV, Chapter 5, Section 4 that already contain an LGD assumption, the LGD in the formula used shall be 100 %.
6. Institutions shall provide senior management and the appropriate committee of the management body with regular reports on both Specific and General Wrong-Way risks and the steps being taken to manage those risks.
Draft Commission Delegated Regulation supplementing Regulation (EU) No 648/2012 on OTC derivatives, central counterparties and trade repositories of the European Parliament and of the Council with regard to regulatory technical standards for risk-mitigation techniques for OTC derivative contracts not cleared by a CCP (attached to the ESAs' Second Consultation on margin RTS for non-cleared derivatives of 10 June 2015 (JC/CP/2015/002)
The value of collateral should not exhibit a significant correlation with the creditworthiness of the collateral provider or the value of the underlying non-centrally cleared derivatives portfolio because this would undermine the effectiveness of the protection offered by the collateral collected. Accordingly, securities issued by the collateral provider or its related entities should not be accepted as collateral. Counterparties should be required to monitor that collateral collected is not subject to more general forms of wrong way risk.
Article 6 LEC - Eligibility criteria to avoid wrong way risk
1. The risk management procedures required for compliance with paragraph 3 of Article 11 of Regulation (EU) No 648/2012, shall ensure that securities referred to in points (f), (g) and (k) to (r) of Article 1 LEC fulfil all of the following criteria:
(a) they are not issued by the posting counterparty;
(b) they are not issued by entities which are part of the same group, as defined in Article 2(16) of Regulation 648/2012, as that of the posting counterparty, nor by entities which have close links with the posting counterparty, as defined in Article 2 (24) of Regulation (EU) No 648/2012; (c) they are not otherwise subject to significant wrong way risk, as defined in Article 291 of Regulation (EU) 575/2013.
Final Draft Regulatory Technical Standards of 8 March 2016 on risk-mitigation techniques for OTC-derivative contracts not cleared by a CCP under Article 11(15) of Regulation (EU) No 648/2012 (document of the Joint Committee of European Supervisory Authorities (ESAs): the European Banking Authority (EBA), the European Insurance and Occupational Pensions Authority (EIOPA) and the European Securities and Markets Authority (ESMA), ESAs 2016 23),
The value of collateral should not exhibit a significant correlation with the creditworthiness of the collateral provider or the value of the underlying non-centrally cleared derivatives portfolio, since this would undermine the effectiveness of the protection offered by the collateral collected. Accordingly, securities issued by the collateral provider or its related entities should not be accepted as collateral. Counterparties should be required to monitor that collateral collected is not subject to more general forms of wrong way risk.
Eligibility criteria to avoid wrong way risk
1. The risk management procedures shall ensure that the asset classes referred to in points (f), (g) and (k) to (r) of Article 22(2) also fulfil all of the following criteria:
(a) they are not issued by the posting counterparty;
(b) they are not issued by entities which are part of the group to which the posting counterparty belongs;
(c) they are not otherwise subject to significant wrong way risk, as defined in paragraph 1 of Article 291 of Regulation (EU) 575/2013.
2. Points (a), (b) and (c) of paragraph 1 shall apply to the risk exposures arising from third party holders or custodians holding initial margin collected in cash.
"In some instances, the risk of exposure to SWWR may be evident for certain cleared products. In the credit default swap context, SWWR may arise where a participant seeks to clear a product that references its own name or the name of an affiliate. Another related area where a CCP can be sensitive to exposures that may give rise to SWWR is the specific positions that participants or their customers may clear. As already discussed, this is an area where certain examples (ie clearing of products in the same name as a participant or customer) are well known. However, the ways in which a CCP may address SWWR in this context can vary depending on the circumstances. As a general matter, a CCP should have in place frameworks that identify, monitor and manage self-referencing or other highly correlated positions maintained by participants and their customers at the CCP. Such frameworks might include increased margin requirements for such positions, including through the application of add-on charges. Another potential approach could entail enhanced collateral requirements where, for example, the notional value of a cleared transaction that reflects a short position in the direct participant's equity or debt needs to be fully collateralised.
In addition to concerns over how positions cleared at a CCP may give rise to SWWR, a CCP should also keep in mind how other aspects of its operations affect risk exposure. For example, all CCPs collect collateral from their participants based on specific margin system requirements and methodologies. In this context, a CCP should consider whether the type of collateral it accepts or other aspects of its margin systems create exposures to SWWR, and should use suitable, sufficient and transparent methods to identify risks arising from the interconnection between the creditworthiness of participants (and customers, as applicable) and respective risk exposures. For example, a CCP could incorporate SWWR into its collateral acceptance policy through the imposition of collateral limits or constraints to mitigate SWWR, to the extent practicable. In addition, a CCP could prevent participants or their customers, as appropriate, from posting collateral where there is a correlation between the creditworthiness of a participant (or customer) and the value of the collateral it has posted to the CCP. Another potential approach could entail a CCP imposing limits on collateral eligibility for certain securities based on average daily trading volume of such securities."
Committee on Payments and Market Infrastructures, Board of the International Organization of Securities Commissions, Consultative Report, Resilience and recovery of central counterparties (CCPs): Further guidance on the PFMI, August 2016