QA2019-86 - Structured Notes

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Feb 01, 2024
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Resolution Reporting Subject Matter Guidance
Guidance Documents Structured-liabilities
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QA2019-86

Question


The difference between structured notes and debt instruments with variable remuneration is not always clear. Therefore, the definition of both should be clarified. According to the Guidance, structure notes are: “debt obligations that contain an embedded derivative component, with returns linked to an underlying security or index”. IFRS 9 in its paragraph 4.3.1 states the following: “An embedded derivative is a component of a hybrid contract that also includes a non-derivative host, with the effect that some of the cash flows of the combined instrument vary in a way similar to a stand-alone derivative. A derivative that is attached to a financial instrument but is contractually transferable independently of that instrument, or has a different counterparty, is not an embedded derivative, but a separate financial instrument”. In order to identify an embedded derivative, IFRS 9 paragraph 4.3.3. states the following, which is not always clear when looking at issuances prospectus: “If a hybrid contract contains a host that is not an asset within the scope of this Standard, an embedded derivative shall be separated from the host and accounted for as a derivative under this Standard if, and only if: (a) the economic characteristics and risks of the embedded derivative are not closely related to the economic characteristics and risks of the host (see paragraphs B4.3.5 and B4.3.8); (b) a separate instrument with the same terms as the embedded derivative would meet the definition of a derivative; and (c) the hybrid contract is not measured at fair value with changes in fair value recognized in profit or loss (ie a derivative that is embedded in a financial liability at fair value through profit or loss is not separated).” Therefore, it is not clear to us whether in the following issuances there is an embedded derivative or not, leading (or not) to classify the instrument as a structure note: Example 1: Debt security that pays the following coupons: - 20 first coupons: Reference rate (Euribor) minus 0,50%. - Coupons 21, 25, 29, 33, 37, 41, 45, 49, 53, 57: Reference date (Euribor) minus 0,50% plus Dv, where: Dv = 5*max(0%, -0.10% - TDn) TDn = CMS10n – CMS2n CMS = Credit Marginal Swap rate for n years. - Other coupons: Reference date (Euribor) minus 0,50% plus Dv, where: Dv= “Dv from previous year” +5*max (0%, -0.10% - TDn) TDn = CMS10n – CMS2n CMS = Credit Marginal Swap rate for n years Example 2: Debt security that pays the following coupons: - Year 1- 8: 1,5% - Year 9-14: 2,3% - Year 15: 2,3% + “Inf”, where Inf = inflation in Spain accumulated during the issuance life; IPC = Consumer Price Index ; Example 3: Debt security that pays the following coupons: - Years 1-4: CPI + 0.20% - Years 5-11: CPI + 1.50% - Years 12-15: CPI + 1.75% where CPI (Consumer Price Index) Example 4: Debt security that pays the following coupons: - Years 1-5: 6% - Years 6-20: Max [ 0% ; Min { 125%xCMS30y; 20x(CMS30y-CMS2y) }] where CMS30y, Constant Maturity Swap type 30 years, CMS2y, Constant Maturity Swap Index 2 years. Finally, it should be taken into account that a structured deposit is not a structured note, as already explained in Q&A56: “In general for reporting purposes, an instrument shall only be classified as a deposit where it is legally determined as such (thus excluding notes or other loans and securities)”.


Response


The LDR guidance defines structured notes in line with the "Instructions for Basel III monitoring" issued by the BCBS, as debt obligations that contain an embedded derivative component, with returns linked to an underlying security or index (public or bespoke, such as equities or bonds, fixed income rates or credit, FX, commodities etc.). Structured notes do not include debt instruments that include call or put options only, i.e. the value of the instrument does not depend on any embedded derivative component. This is for the banks to assess the structuration of the notes on a case by case basis.