CHAPTER V

COVERED SOVEREIGN CREDIT DEFAULT SWAPS PURSUANT TO ARTICLE 4(2)

Cases which are not uncovered sovereign credit default swap positions
Article 14
1
In the following cases a sovereign credit default swap position shall not be considered an uncovered position in accordance with Article 4(1) of Regulation (EU) No 236/2012.
a
In respect of hedges for the purpose of Article 4(1)(b) of Regulation (EU) No 236/2012, the sovereign credit default swap shall not be considered an uncovered position in accordance with Article 4(1) of Regulation (EU) No 236/2012 and shall serve to hedge against the risk of decline in the value of assets or liabilities correlated with the risk of the decline of the value of the sovereign debt which the credit default swap references and where those assets or liabilities refer to public or private sector entities in the United Kingdom.
b
A sovereign credit default swap position, in which assets or liabilities refer to public or private sector entities in the United Kingdom as the reference sovereign for the credit default swap, shall not be considered an uncovered position in accordance with Article 4(1) of Regulation (EU) No 236/2012 where it:
1. references the United Kingdom, including any government department, agency or special purpose vehicle of the United Kingdom;
2. is used to hedge any assets or liabilities meeting the correlation test set out in Article 18.
c
A sovereign credit default swap position, where the assets or liabilities refer to a sovereign issuer in which the reference sovereign for the credit default swap is a guarantor or shareholder, shall not be considered an uncovered position in accordance with Article 4(1) of Regulation (EU) No 236/2012 where it:
1. references the United Kingdom;
2. is used to hedge any assets or liabilities meeting the correlation test set out in Article 18.
2
For the purposes of point (a) of paragraph 1, a correlation shall exist between the value of the asset or liability being hedged and the value of the referenced sovereign debt as set out in Article 18.

Cases which are not uncovered sovereign credit default swap positions where the obligor is established or the asset or liability is located in the United Kingdom and a third country
Article 15
1
Where the obligor of, or counterparty to, an asset or liability is established in the United Kingdom and a third country a sovereign credit default swap position shall not be considered an uncovered position in the following cases, in accordance with Article 4(1) of Regulation (EU) No 236/2012, and provided that the correlation test in Article 18 of this Regulation is met in each case:
a
where there is a parent company in a third country and a subsidiary in the United Kingdom and a loan has been made to the subsidiary. Where there is either explicit or implicit credit support to the subsidiary by the parent, it shall be permissible to purchase sovereign credit default swaps in the country of the parent rather than the subsidiary;
b
where there is a parent holding company which own or controls a subsidiary operating company in a third country. If the parent company is the issuer of the bond but the assets and revenues that are hedged are owned by the subsidiary, it shall be permissible to buy sovereign credit default swaps referenced to the country of the subsidiary;
c
to hedge an exposure to a company in the United Kingdom which has invested in the sovereign debt of a third country to the extent that that company would be significantly impacted in the event of a significant fall in the value of the sovereign debt of the third country, provided that the company is established in the United Kingdom and the third country. Where the correlation between this risk and the debt of the third country is greater than the correlation between this risk and the debt of the United Kingdom it shall be permissible to buy sovereign credit default swaps referenced to the third country.
2
A sovereign credit default swap position shall not be considered an uncovered position in the following cases, in accordance with Article 4(1) of Regulation (EU) No 236/2012, and provided that the correlation test in Article 18 of this Regulation is met in each case:
a
where the obligor of, or counterparty to, an asset or liability being hedged is a company which has operations in the United Kingdom and in a third country or where the exposure being hedged relates to the Union or the Member States which have the euro as their currency, it shall be permissible to hedge it with an appropriate European or euro area index of sovereign bond credit default swaps;
b
where the counterparty to an asset or liability being hedged is a supra-national issuer, it shall be permissible to hedge the counterparty risk with an appropriately chosen basket of sovereign credit default swaps referencing that entity’s guarantors or shareholders.
3
For the purposes of this Regulation, “
sovereign debt
” in relation to a third country means a debt instrument issued by—
a
a third country, including a government department, an agency or a special purpose vehicle of the third country; or
b
in the case of a federal country, a member of the federation.
4
For the purposes of this Article, “
supra-national issuer
” means—
a
the Union;
b
a special purpose vehicle for several third countries;
c
an international financial institution established by two or more countries which has the purpose of mobilising funding and providing financial assistance to the benefit of its members that are experiencing or threatened by severe financing problems; or
d
the European Investment Bank.

Justification of uncovered sovereign credit default swap positions
Article 16
Any natural or legal person entering into a sovereign credit default swap position shall, on the request of the FCA:
1. justify to the FCA which of the cases set out in Article 15 were fulfilled at the time the position was entered into;
2. demonstrate to the FCA compliance with the correlation test in Article 18 and the proportionality requirements in Article 19 in respect of that sovereign credit default swap position at any time that they hold that sovereign credit default swap.

Hedged assets and liabilities
Article 17
The following are cases where assets and liabilities may be hedged through a sovereign credit default swap position, provided the conditions set out in Articles 15 and 18 and in Regulation (EU) No 236/2012 are met:
1. a long position in the sovereign debt of the relevant issuer;
2. any position or portfolio used in the context of hedging exposures to the sovereign issuer referenced in the credit default swaps;
3. any assets or liabilities which refer to public sector entities in the United Kingdom. This includes exposures to central, regional and local administration, public sector entities or any exposure guaranteed by the referred entity and may include financial contracts, a portfolio of assets or financial obligations, interest rate or currency swap transactions where the sovereign credit default swap is used as a counterparty risk management tool for hedging exposure on financial or foreign trade contracts;
4. exposures to private sector entities established in the United Kingdom. The exposures in question include but are not limited to loans, counterparty credit risk (including potential exposure when regulatory capital is required for such exposure), receivables and guarantees. The assets and liabilities include but are not limited to financial contracts, a portfolio of assets or financial obligations, interest rate or currency swap transactions where the sovereign credit default swap is used as a counterparty risk management tool for hedging exposure on financial contracts or trade finance exposures;
5. any indirect exposures to any of the above entities obtained through exposure to indices, funds or special purpose vehicles.

Correlation tests
Article 18
1
The correlation test referred to in this Chapter shall be met in either of the following cases:
a
the quantitative correlation test shall be met by showing a Pearson’s correlation coefficient of at least 70 % between the price of the assets or liabilities and the price of the sovereign debt calculated on a historical basis using data for at least a period of 12 months of trading days immediately preceding the date when the sovereign credit default swap position is taken out;
b
the qualitative correlation shall be met by showing meaningful correlation, which means a correlation that is based on appropriate data and is not evidence of a merely temporary dependence. The correlation shall be calculated on a historical basis using data for the 12 months of trading days before the sovereign credit default swap position is taken out, weighted to the most recent time. A different time-frame shall be used if it is demonstrated that the conditions prevailing in that period were similar to those at the time that the sovereign credit default swap position is to be taken out or which would occur in the period of the exposure being hedged. For assets for which there is not a liquid market price or where there is not a sufficiently long price history, an appropriate proxy shall be used.
2
The correlation test in paragraph 1 shall be deemed to have been met if it can be demonstrated that:
a
the exposure being hedged relates to an enterprise which is owned by the sovereign issuer or where the sovereign issuer owns a majority of its voting share capital or whose debts are guaranteed by the sovereign issuer;
b
the exposure being hedged relates to a regional, local or municipal government of the United Kingdom;
c
the exposure being hedged relates to an enterprise whose cash flows are significantly dependent on contracts from a sovereign issuer or a project which is funded or significantly funded or underwritten by a sovereign issuer, such as an infrastructure project.
3
The relevant party shall justify that the correlation test was met at the time that the sovereign credit default swap position was entered into upon request by the FCA.

Proportionality
Article 19
1
In determining whether the size of the sovereign credit default swap position is proportionate to the size of the exposures hedged, where a perfect hedge is not possible, an exact match is not required and limited over-provision shall be permitted in accordance with paragraph 2. The relevant party shall justify upon request to the FCA why an exact match was not possible.
2
Where justified by the nature of the assets and liabilities being hedged and their relationship to the value of the obligations of the sovereign which are within the scope of the credit default swap, a greater value of sovereign credit default swap shall be held to hedge a given value of exposures. However, this shall only be permitted where it is demonstrated that a larger value of sovereign credit default swap is necessary to match a relevant measure of risk associated with the reference portfolio, taking into account as the following factors:
a
the size of the nominal position;
b
the sensitivity ratio of the exposures to the obligations of the sovereign which are within the scope of the credit default swap;
c
whether the hedging strategy involved is dynamic or static.
3
It is the responsibility of the position holder to ensure that its sovereign credit default swap position remains proportionate at all times and that the duration of the sovereign credit default swap position is aligned as closely as practicable given prevailing market conventions and liquidity with the duration of the exposures being hedged or the period during which the person intends to hold the exposure. If the exposures being hedged by the credit default swap position are liquidated or redeemed, they must either be replaced by equivalent exposures or the credit default swap position must be reduced or otherwise disposed of.
4
Provided that a sovereign credit default swap position was covered at the time it was entered into, it shall not be treated as becoming uncovered where the sole reason for the position becoming uncovered is a fluctuation in the market value of the hedged exposures or the value of the sovereign credit default swap.
5
In all circumstances, where parties accept a sovereign credit default swap position as a consequence of their obligations as members of a central counterparty which clears sovereign credit default swap transactions and as a result of the operation of the rules of that central counterparty, such a position shall be treated as involuntary and not as a position that the party has entered into and so shall not be considered uncovered pursuant to Article 4(1) of Regulation (EU) No 236/2012.

Method of calculation of an uncovered sovereign credit default swap position
Article 20
1
The calculation of a natural or legal person’s sovereign credit default swap position shall be its net position.
2
When calculating the value of the eligible risks hedged or to be hedged by a sovereign credit default swap position a distinction shall be made between static and dynamic hedging strategies. For static hedging, such as direct exposures to sovereign or public sector bodies in the sovereign, the metric used shall be the jump to default measure of the loss if the entity to which the position holder is exposed defaults. The resulting value shall then be compared against the net notional value of the credit default swap position.
3
When calculating the value of market value adjusted risks for which a dynamic hedging strategy is required, the calculations must be undertaken on a risk-adjusted rather than notional basis, taking into account the extent to which an exposure might increase or decrease during its duration and the relative volatilities of the assets and liabilities being hedged and of the referenced sovereign debt. A beta adjustment shall be used if the asset or liability for which the credit default swap position is being used as a hedge is different from the reference asset of the credit default swap.
4
Indirect exposures to risks, such as through indices, funds, special purpose vehicles, and to credit default swap positions shall be taken into account in proportion to the extent the reference asset, liability or credit default swap is represented in the index, fund or other mechanism.
5
The value of the eligible portfolio of assets or liabilities to be hedged shall be deducted from the value of the net credit default swaps position held. If the resulting number is positive the position shall be considered to be an uncovered credit default swaps position in accordance with Article 4(1) of Regulation (EU) No 236/2012.
Words in Art. 14(1)(a) substituted (31.12.2020) by The Short Selling (Amendment) (EU Exit) Regulations 2018 (S.I. 2018/1321), regs. 1(2), 15(5)(a) (with savings in S.I. 2019/680, reg. 11); 2020 c. 1, Sch. 5 para. 1(1)
Words in Art. 14(1)(b) substituted (31.12.2020) by The Short Selling (Amendment) (EU Exit) Regulations 2018 (S.I. 2018/1321), regs. 1(2), 15(5)(b) (with savings in S.I. 2019/680, reg. 11); 2020 c. 1, Sch. 5 para. 1(1)
Art. 14(1)(b)(i) substituted (31.12.2020) by The Short Selling (Amendment) (EU Exit) Regulations 2018 (S.I. 2018/1321), regs. 1(2), 15(5)(c) (with savings in S.I. 2019/680, reg. 11); 2020 c. 1, Sch. 5 para. 1(1)
Words in Art. 14(1)(c)(i) substituted (31.12.2020) by The Short Selling (Amendment) (EU Exit) Regulations 2018 (S.I. 2018/1321), regs. 1(2), 15(5)(d) (with savings in S.I. 2019/680, reg. 11); 2020 c. 1, Sch. 5 para. 1(1)
Words in Art. 15 heading substituted (31.12.2020) by The Short Selling (Amendment) (EU Exit) Regulations 2018 (S.I. 2018/1321), regs. 1(2), 15(6)(a) (with savings in S.I. 2019/680, reg. 11); 2020 c. 1, Sch. 5 para. 1(1)
Art. 15(3)(4) inserted (31.12.2020) by The Short Selling (Amendment) (EU Exit) Regulations 2018 (S.I. 2018/1321), regs. 1(2), 15(6)(d) (with savings in S.I. 2019/680, reg. 11); 2020 c. 1, Sch. 5 para. 1(1)
Words in Art. 15(1) substituted (31.12.2020) by The Short Selling (Amendment) (EU Exit) Regulations 2018 (S.I. 2018/1321), regs. 1(2), 15(6)(b)(i) (with savings in S.I. 2019/680, reg. 11); 2020 c. 1, Sch. 5 para. 1(1)
Words in Art. 15(1)(a) substituted (31.12.2020) by The Short Selling (Amendment) (EU Exit) Regulations 2018 (S.I. 2018/1321), regs. 1(2), 15(6)(b)(ii)(cc) (with savings in S.I. 2019/680, reg. 11); 2020 c. 1, Sch. 5 para. 1(1)
Words in Art. 15(1)(b) substituted (31.12.2020) by The Short Selling (Amendment) (EU Exit) Regulations 2018 (S.I. 2018/1321), regs. 1(2), 15(6)(b)(iii)(bb) (with savings in S.I. 2019/680, reg. 11); 2020 c. 1, Sch. 5 para. 1(1)
Words in Art. 15(1)(c) substituted (31.12.2020) by The Short Selling (Amendment) (EU Exit) Regulations 2018 (S.I. 2018/1321), regs. 1(2), 15(6)(b)(iv)(dd) (with savings in S.I. 2019/680, reg. 11); 2020 c. 1, Sch. 5 para. 1(1)
Words in Art. 15(2)(a) substituted (31.12.2020) by The Short Selling (Amendment) (EU Exit) Regulations 2018 (S.I. 2018/1321), regs. 1(2), 15(6)(c) (with savings in S.I. 2019/680, reg. 11); 2020 c. 1, Sch. 5 para. 1(1)
Words in Art. 15(1)(a) substituted (31.12.2020) by The Short Selling (Amendment) (EU Exit) Regulations 2018 (S.I. 2018/1321), regs. 1(2), 15(6)(b)(ii)(aa) (with savings in S.I. 2019/680, reg. 11); 2020 c. 1, Sch. 5 para. 1(1)
Words in Art. 15(1)(a) substituted (31.12.2020) by The Short Selling (Amendment) (EU Exit) Regulations 2018 (S.I. 2018/1321), regs. 1(2), 15(6)(b)(ii)(bb) (with savings in S.I. 2019/680, reg. 11); 2020 c. 1, Sch. 5 para. 1(1)
Words in Art. 15(1)(b) substituted (31.12.2020) by The Short Selling (Amendment) (EU Exit) Regulations 2018 (S.I. 2018/1321), regs. 1(2), 15(6)(b)(iii)(aa) (with savings in S.I. 2019/680, reg. 11); 2020 c. 1, Sch. 5 para. 1(1)
Words in Art. 15(1)(c) substituted (31.12.2020) by The Short Selling (Amendment) (EU Exit) Regulations 2018 (S.I. 2018/1321), regs. 1(2), 15(6)(b)(iv)(aa) (with savings in S.I. 2019/680, reg. 11); 2020 c. 1, Sch. 5 para. 1(1)
Words in Art. 15(1)(c) substituted (31.12.2020) by The Short Selling (Amendment) (EU Exit) Regulations 2018 (S.I. 2018/1321), regs. 1(2), 15(6)(b)(iv)(bb) (with savings in S.I. 2019/680, reg. 11); 2020 c. 1, Sch. 5 para. 1(1)
Words in Art. 15(1)(c) substituted (31.12.2020) by The Short Selling (Amendment) (EU Exit) Regulations 2018 (S.I. 2018/1321), regs. 1(2), 15(6)(b)(iv)(cc) (with savings in S.I. 2019/680, reg. 11); 2020 c. 1, Sch. 5 para. 1(1)
Words in Art. 16 substituted (31.12.2020) by The Short Selling (Amendment) (EU Exit) Regulations 2018 (revoked) 2018 (S.I. 2018/1321), regs. 1(2), 15(7)(a) (with savings in S.I. 2019/680, reg. 11); 2020 c. 1, Sch. 5 para. 1(1)
Words in Art. 16(a)(b) substituted (31.12.2020) by The Short Selling (Amendment) (EU Exit) Regulations 2018 (revoked) 2018 (S.I. 2018/1321), regs. 1(2), 15(7)(b) (with savings in S.I. 2019/680, reg. 11); 2020 c. 1, Sch. 5 para. 1(1)
Words in Art. 17(c) substituted (31.12.2020) by The Short Selling (Amendment) (EU Exit) Regulations 2018 (S.I. 2018/1321), regs. 1(2), 15(8)(a) (with savings in S.I. 2019/680, reg. 11); 2020 c. 1, Sch. 5 para. 1(1)
Words in Art. 17(d) substituted (31.12.2020) by The Short Selling (Amendment) (EU Exit) Regulations 2018 (S.I. 2018/1321), regs. 1(2), 15(8)(b) (with savings in S.I. 2019/680, reg. 11); 2020 c. 1, Sch. 5 para. 1(1)
Words in Art. 18(2)(b) substituted (31.12.2020) by The Short Selling (Amendment) (EU Exit) Regulations 2018 (S.I. 2018/1321), regs. 1(2), 15(9)(a) (with savings in S.I. 2019/680, reg. 11); 2020 c. 1, Sch. 5 para. 1(1)
Words in Art. 18(3) substituted (31.12.2020) by The Short Selling (Amendment) (EU Exit) Regulations 2018 (S.I. 2018/1321), regs. 1(2), 15(9)(b) (with savings in S.I. 2019/680, reg. 11); 2020 c. 1, Sch. 5 para. 1(1)
Words in Art. 19 substituted (31.12.2020) by The Short Selling (Amendment) (EU Exit) Regulations 2018 (S.I. 2018/1321), regs. 1(2), 15(10) (with savings in S.I. 2019/680, reg. 11); 2020 c. 1, Sch. 5 para. 1(1)