The FRB recently released an interpretive letter addressed to Morgan Stanley Bank, N.A. (“Morgan Stanley Bank”) in which the FRB’s General Counsel addressed the manner in which Morgan Stanley Bank should determine the value of transactions involving the novation to Morgan Stanley Bank of certain foreign exchange (“FX”) derivatives contracts between affiliates of Morgan Stanley Bank and third parties.
As described in the interpretive letter, through the novation process, Morgan Stanley Bank would succeed to the rights and obligations of its affiliates with respect to the FX derivatives. The interpretive letter states that the proposed novations are covered transactions for purposes of Section 23A of the Federal Reserve Act because Morgan Stanley Bank would purchase an asset—the right to receive payments from the counterparties to the FX derivatives being novated—from each affiliate novating FX derivative contracts in exchange for agreeing to assume all of such affiliate’s obligations under those contracts. The interpretive letter explains how Morgan Stanley Bank should value the transactions for purposes of determining the aggregate amount of covered transactions outstanding between Morgan Stanley Bank and its affiliates. For this purpose, under the methodology described in the letter, Morgan Stanley Bank would be required to determine, on a daily basis, its full risk exposure resulting from the novations from any single affiliate by adding (i) the amount of all payments made by Morgan Stanley Bank to or for the benefit of the affiliate in connection with any novation, (ii) the aggregate absolute value of the negative current exposure of all novated contracts or derivative netting sets that have negative current exposure at the time of novation (i.e., an amount by which the contracts are “out of the money”), (iii) the amount of a “counterparty credit risk measure” determined in the manner specified in the interpretive letter (which takes into account both current and potential future credit exposure to the counterparties), and (iv) the amount of a “market risk measure” determined in the manner specified in the interpretive letter. However, Morgan Stanley Bank would be permitted to reduce this amount by deducting (i) any payments made by the affiliate to Morgan Stanley Bank, (ii) the aggregate amount of any qualifying collateral or margin held by Morgan Stanley Bank with respect to the novated derivative contracts or netting sets, and (iii) the amount of qualifying collateral or margin previously posted by the affiliate to a counterparty so long as the affiliate transfers to Morgan Stanley Bank all current and future rights to the collateral. The interpretive letter states that it applies only to FX derivatives contracts and only in the context of the specific transactions proposed by Morgan Stanley Bank and that other types of derivatives or other transactions may be subject to a different valuation methodology. Further, the interpretive letter states that Morgan Stanley Bank would be required to comply with any valuation methodology required by any revision of the FRB’s Regulation W, as applicable.