New Modalities of Credit Derivative Transactions in Brazil

Co-written by Adriana M Gödel Stuber

Under the terms of Resolution nº 2933, of February 28, 2002, the Brazilian Monetary Council authorizes the financial and other institutions accredited with the Brazilian Central Bank (Banco Central do Brasil - Bacen) to carry out certain credit derivative transactions according to terms and conditions to be established by Bacen.

According to the regulations in force, the financial and other institutions authorized to act as the receiver of credit risks are the multi-service, commercial and investment banks; the Federal Savings Banks; loan, finance and investment companies; real estate loan and leasing companies. In the specific case of leasing companies, the transaction may only occur if the underlying asset relates to credits deriving from leasing transactions.

The parties involved in this kind of transaction are the party transferring the risk and the party receiving the risk. The first acquires, by means of a credit derivative contract, the protection against a certain credit risk by making the mutually agreed payment. The second assumes, under the same credit derivative contract, the risk inherent in the respective underlying asset and undertakes to pay the mutually agreed compensation to the party transferring the risk if any event foreseen in the contract occurs.

Therefore, credit derivatives are the contracts wherein the parties bargain credit risk of transactions without the underlying asset being transferred at the time of transaction.

According to the Brazilian Monetary Council and Bacen, "underlying asset" is any credit deriving from loan, financing and leasing transactions; credit instruments; securities; guarantees; sureties; credit derivatives and other instruments and financial or commercial agreements subject to a credit risk that are negotiated and performed domestically. As a general rule, the party transferring the risk must necessarily hold the credit risk. Nevertheless, there is in exception to this general rule. Such rule does not apply if the transaction involves in underlying asset that trades usually on organized markets and whose pricing can be confirmed.

If the underlying asset is in portfolio, the credit risk transfer party will make available to Bacen all records that attest to the existence of risk of the underlying asset at the time the credit derivative is contracted. The risk transfer amount is limited to the value of the underlying asset. Additionally, it is expressly forbidden any assignment, disposal or transfer, whether directly or indirectly, under any pretext, of the underlying asset during the term of the credit derivative contract indexed thereby.

In Circular nº 3106, of April 10, 2002 Bacen establishes that two modalities of credit derivative are allowed: (i) credit swap; and (ii) total return rate swap. According to the definition contained in Circular 3106/02, swap transactions are transactions performed between the party transferring the risk and the party receiving the risk for forward settlement and that imply, upon occurrence of events called "credit deterioration events" or simply "credit events", total or partial restoration of the reference value set forth in the contract in favor of the party transferring the risk. It is, therefore, a mechanism that allows one having a high-risk credit portfolio to hire the services of a financial institution so that said risk is transferred to a third party willing to take it on. In exchange, said third party will be adequately remunerated for assuming the risk.

The first modality of credit swap occurs when the party receiving the risk is remunerated based on a protection rate, that is, with a prefixed margin. The second swap modality is the total return rate swap and occurs when the party is remunerated based on the flow of charges and underlying asset-related considerations received. To better illustrate this swap modality, here is an example: in the case of loan, the compensation for assuming the risk refers to payment of interest on the debt’s principal.

"Credit events" must be expressly provided in a contract and are those events related to the underlying asset or its obligors that, irrespective of intention, cause the payment, by the party receiving the risk, of protection hired by the party transferring it. The following situations, at least, must be contractually established as "credit events":

• Declaration in bankruptcy or insolvency of obligors of the underlying asset;
• File for composition with creditors (concordata preventiva) of the obligors of the underlying asset;
• judicial or extrajudicial liquidation of the obligors of the underlying asset;
• reorganization of the obligors’ liabilities, when representing loss in value or deterioration of quality of the underlying asset receivable;
• change in control, amalgamation or merger of the obligors, when representing loss in value or deterioration of quality of the underlying asset receivable;
• moratorium of the obligors of the underlying asset;
• default of the underlying asset;
• mandatory acceleration of payment of the underlying asset, if contractually provided for;
• judicial denial or dispute of the underlying asset.

In order for the transfer of credit risk of an underlying asset to be considered effective, the following minimum requirements must be met:

1. the contract provides, at least, the above-mentioned situations as "credit events";
2. the transfer of the underlying asset must be legally possible, in the cases where the credit derivative contract so provides upon the occurrence of a "credit event";
3. there can be no co-obligation of the party transferring the risk in relation to the portion of the underlying asset object of the transaction;
4. there can be no clause allowing for unilateral cancellation of the contract by the party receiving the credit risk, except in the case of non-payment by the party transferring the risk of the remuneration owing to the party receiving it;
5. there can be no clause that allows the party receiving the risk not to comply with the obligation to promptly pay the amount owing to the party transferring the risk upon the occurrence of a "credit event."

The regulation expressly prohibits the following transactions:

1. options connected to the credit swap and total return rate swap modalities;
2. credit derivatives between controlling, connected controlled individuals or legal entities, including "similar entities". "Similar entities" as used in this article, are companies located in Brazil and abroad of which financial and other institutions accredited by Bacen hold, directly or indirectly, separately or collectively with other partners, including by virtue of voting or partners’ rights agreements that ensure separately or cumulatively: (i) prevalence at corporate decisions; (ii) power to elect or remove the majority officers; (iii) effective operating control, characterized by the common administration or management; and/or (iv) controlling interest represented by the sum of interests held by the institution, irrespective of percentage, and those held by the officers, controlling and associated companies, as well as by those directly or indirectly acquired by means of investment funds. Furthermore, transactions between financial and other institutions accredited by Bacen and companies located abroad, wherein the same controlling companies there is interest held by the same controlling persons of those institutions or control when said controlling persons are resident and domiciled in Brazil, as well as transactions carried our by means of companies in Brazil, associated or subject to common financial control and other institutions accredited by Bacen. That is, the concept of "similar entities" encompasses the companies mentioned here, whose swap transactions are also forbidden;
3. assumption of credit risk by those listed in item (2) above; and
4. credit derivatives whose flows are not denominated in the same currency or by the same index as the underlying asset.

The swap transactions carried out by the party transferring the risk, so long as it is the party holding, the underlying asset directly or indirectly by means of a credit derivative transaction, may, at the option of the financial institution, be taken into account in the calculation of institution’s own Required Net Worth (Patrimônio Líquido Exigido - PLE), in view of the level of transfer of credit risk of the underlying asset.

The party transferring the risk may benefit from the credit derivative transaction, to the extent of the risk being transferred, so long as it directly holds the underlying asset or indirectly holds it by means of a credit derivative transaction, due respect being given to the minimum requirements for the effectiveness of the transfer of the credit risk of the underlying asset, as previously discussed. The party transferring the risk is also required to take into account the credit derivative transaction, to the extent of risk being transferred, in the exposure limit related to the party receiving the risk.

The party receiving the risk, on the other hand, is exposed to the underlying asset’s risk to the extent of the risk being assumed, and must, in relation to the risk exposure, abide by the rules in force applicable to the exposure limits per client and establish specific provision.

In the case of credit derivative transactions, financial institutions must publish explanatory notes in their financial statements containing at least the following information:

1. institution’s policy, purposes and strategies;
2. volumes of credit risks received and transferred (book and market values), total and for the period;
3. impact (increase or decrease) on the calculation of the PLE;
4. amount and features of the credit transactions transferred or received in the period as a result of the facts provided in contract; and
5. separation by type (credit swap and total return rate swap).

Regardless of being the receiver or transferor of risk, the financial institutions must make available to Bacen adequate records of their policy and procedures applicable to credit derivative transactions, as well as established exposure limits. Bacen must be duly informed of any credit derivative contract whose accumulated amount of transactions on one single side equals to or exceeds 10% of the Reference Equity of any of the institutions acting as parties to the contract. The financial institutions must inform the Department of Registration and Financial System Information (Departamento de Cadastro e Informações do Sistema Financeiro - Decad) the name of the person in charge of the credit derivative transactions.

Therefore, as of the effective date of Circular nº 3106/02, Bacen allows two modalities of credit derivative, that is credit and total return rate swaps.