BOAR D O F GOVERNORS 

O F TH E 

FEDERAL RESERVE SYSTEM 

WASHINGTON , D. C. 2055 1 

[official seal of the board of 

governors of the federal reserve system.] 

SCOT T G. ALVARE Z 

GENERAL COUNSE L 

November 5, 2012 

Andrew S. Baer, Esq. 

General Counsel 

Morgan Stanley Bank, N.A. 

1221 Avenue of the Americas 

New York, NY 10020 

Dear Mr. Baer: 

This is in response to the request by Morgan Stanley Bank, N.A. 

("MS Bank"), Salt Lake City, Utah, for the view of staff of the Federal Reserve 

Board about how to determine, for purposes of sections 23 A and 23B of the 

Federal Reserve Act and the Board's Regulation W, the value of transactions that 

involve the novation from MS Bank's affiliates to the bank of foreign exchange 

(FX) derivatives between the affiliates and unaffiliated third-party clients. 

Section 23A and Regulation W place quantitative and qualitative 

restrictions on covered transactions between a bank and its affiliates. In general, 

section 23A and Regulation W limit the total amount of covered transactions 

between a bank and any single affiliate to 10 percent of the bank's capital stock 

and surplus, and limit the total amount of covered transactions between a bank and 

all its affiliates to 20 percent of the bank's capital stock and surplus. 

[footnote] 1

 12 U.S.C. §371c(a)(l); 12CFR223.11 and 223.12. Section 23A and 

Regulation W contain certain exceptions to these limits not relevant here. [end of footnote.] 

In addition, 

section 23 A and Regulation W prohibit a bank from purchasing low-quality assets 

from an affiliate 

[footnote] 2

 12 U.S.C. §371c(a)(3) and 12 CFR 223.15. [end of footnote.] 

and require that a covered transaction between a bank and an 

affiliate be on terms that are consistent with safe and sound banking practices. 

[footnote] 3

 12 U.S.C. § 371c(a)(4) and 12 CFR223.13. [end of footnote.] 

The statute and regulation also require a bank to secure certain covered 

transactions with prescribed amounts of collateral. 

[footnote] 4

 12 U.S.C. §371c(c) and 12 CFR 223.14. [end of footnote.] 

Section 23B generally requires 
that transactions between a bank and its affiliates be on terms that are at least as 

favorable to the bank as the terms of comparable transactions between the bank 

and a third party. 

[footnote] 5

 12 U.S.C. § 371c-1(a). Effective July 21, 2012, the Dodd-Frank Wall Street 

Reform and Consumer Protection Act ("Dodd-Frank Act") revised section 23 A to 

include as a covered transaction the credit exposure of a bank to an affiliate arising 

from a derivative transaction with the affiliate. Dodd-Frank Act §608(a)(l)(B) 

(codified at 12 U.S.C. § 371c(b)(7)(G)). [end of footnote.] 

Through the novation process as proposed by MS Bank, the bank 

would succeed to the rights and obligations of its affiliate in derivative contracts 

between the affiliate and its counterparties, and the affiliate would be relieved of 

these rights and obligations. The bank does not anticipate paying or receiving any 

consideration for the novation of any derivative transaction, though all collateral 

held or posted by the affiliate related to the transaction would be transferred to the 

bank. After each proposed novation, the counterparty to the derivative contract 

would face MS Bank and not the affiliate with which the counterparty initially 

entered into the contract. 

The proposed novations are covered transactions under section 23A 

and Regulation W because MS Bank's acquisition of the FX derivative 

transactions constitutes a purchase of assets by MS Bank. 

[footnote] 6

 In addition, the proposed novation would be a covered transaction under the 

attribution rule contained in Section 23A. Under section 23A and Regulation W, a 

transaction between a bank and a third party is deemed to be a transaction with an 

affiliate to the extent that the proceeds of the transaction are used for the benefit of, 

or transferred to, an affiliate. 12 U.S.C. § 371c(a)(2) and 12 CFR 223.16(a). The 

assumption by the bank of the obligation to make payments to the counterparty 

under the novated derivative contract benefits the bank's affiliate by relieving the 

affiliate of the obligation to make those payments. [end of footnote.] 

Regulation W defines 

the "purchase of an asset" as the acquisition by a bank of an asset from an affiliate 

in exchange for cash or any other consideration, including an assumption of 

liabilities. 

[footnote] 7

 12 CFR223.3(dd); 12 CFR 223.3(h)(3). [end of footnote.] 

Under the novated derivative contract, the bank would have the right 

to receive payments from the counterparty (an asset) as well as the liability to 

make payments to the counterparty (which is considered by Regulation W to be 
payment for the corresponding right to receive future payments - the asset). 

Following the transaction, MS Bank would be subject to both counterparty credit 

risk (i.e., the risk that the counterparty does not perform its obligations under 

the contract) and market risk (i.e., the risk that the contract decreases in value 

from the perspective of MS Bank) for the novated derivative contract. 

Sections 23 A and 23B of the Federal Reserve Act and Regulation W 

allow covered transactions between a bank and an affiliate so long as the 

transactions are within certain quantitative limits, noted above, and meet certain 

qualitative requirements. MS Bank has requested advice on how to determine the 

covered transaction amount for FX derivative transactions under its proposed 

novation process. 

Valuation of Novated FX Derivative Transactions 

Based on all the facts and circumstances and staffs understanding of 

the novations as proposed by MS Bank, staff would not recommend that the Board 

find MS Bank to be in violation of the quantitative limits in sections 23A and 

Regulation W if the FX derivative transactions are within the quantitative limits 

noted above using the valuation methodology described below and the novations 

otherwise meet the terms of sections 23A and 23B and Regulation W. 

[footnote] 8

 This discussion presumes that MS Bank conforms to the qualitative and other 

requirements contained in sections 23A and 23B and Regulation W in carrying out 

its proposed approach to novations. [end of footnote.] 

Staff has 

considered this approach only in the context of FX derivatives and only in the 

context of the structure for novations proposed by MS Bank. Other types of 

derivatives or other novation structures may merit different valuations. We would 

expect MS Bank to calculate the covered transaction amount on a daily basis for all 

FX derivative transactions that have been novated from an individual affiliate and 

remain outstanding as of the end of the day, 

[footnote] 9

 As a result, the covered transaction amount could change for the bank after the 

novations occur. [end of footnote.] 

and as further described below, 

periodically report its compliance to the Federal Reserve Bank of New York. 

In order to account for the full risk exposure of MS Bank resulting 

from the novations, the bank should apply the quantitative limit of section 23 A for 

any single affiliate to the sum of: 
(i) The aggregate amount of all payments made by MS 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 derivative contracts or novated "derivative netting sets" 

[footnote] 10

 A "derivative netting set" means all derivative contracts with an individual 

counterparty that are governed by contractual arrangements that constitute a 

"qualifying master netting agreement" as defined in 12 CFR part 225, 

appendix G, § 2. The current exposure of a derivative netting set with an 

individual counterparty may be calculated on a net basis with respect to all 

contracts within that derivative netting set. [end of footnote.] 

that have negative current exposure as of the time of novation; 

(iii) A "counterparty credit risk measure" (as defined below) for all 

novated derivative contracts or novated derivative netting sets with 

each individual counterparty; and 

(iv) A "market risk measure" (as defined below) for all derivative 

contracts and derivative netting sets that have been novated from 

that affiliate to MS Bank. 

The covered transaction amount for all derivatives that are novated 

from an individual affiliate may be reduced by the sum of: 

(i) The aggregate amount of all payments made from the affiliate to 

MS Bank in connection with any novation; 

(ii) The aggregate amount of any "qualifying collateral or margin" 

[footnote] 11

 For this purpose, "qualifying collateral or margin" means collateral or margin in 

the form of either (i) cash or (ii) obligations of the United States or its agencies, or 

obligations fully guaranteed by the United States or its agencies as to principal and 

interest, provided that the collateral or margin legally secures a party's obligations 

under the relevant transaction(s) and is identified as such. This reduction in the 

covered transaction amount for this collateral or margin is limited to the valuation 

for novated FX derivative transactions described in this letter, and does not change 

any collateral requirements or other provisions of Regulation W. [end of footnote.] 

held 

by MS Bank (transferred from a counterparty whether at the time of 

novation or thereafter or from the affiliate to MS Bank at novation) 

with respect to a novated derivative contract or derivative netting set; 

and 
(iii) The aggregate amount of any qualifying collateral or margin 

previously posted by the affiliate to a counterparty with respect to a 

novated derivative contract or derivative netting set so long as the 

affiliate transfers to the bank all current and future rights to the 

collateral. 

Counterparty credit risk measure 

Counterparty credit risk is valued similarly to the treatment of 

OTC derivatives under the Board's risk-based capital rules. Under this valuation 

methodology, the counterparty credit risk measure for a derivative contract or 

derivative netting set with each individual novated counterparty would equal the 

exposure at default amount of the contract or netting set as calculated in 

accordance with (i) in the case of an individual derivative contract, 12 CFR 

part 225, appendix G, § 32(c)(5), and (ii) in the case of a derivative netting set, 

12 CFR part 225, appendix G, § 32(c)(6), with the exception that such calculation 

may not be modified by paragraph (c)(7) of that section. 

Market risk measure 

The market risk measure is valued similarly to the capital charge for 

the market risk of a derivative under the Board's market risk rule. 

[footnote] 12

 See 12 CFR part 225, appendix E. [end of footnote.] 

Because the 

Board recently amended its market risk rule effective on January 1, 2013, this 

calculation will change at year end. 

[footnote] 13

Risk-Based Capital Guidelines: Marke t Risk, 77 FR 52587 (August 30, 2012). [end of footno

Specifically, the market risk measure for all 

derivative contracts and derivative netting sets that are novated to MS Bank from 

an individual affiliate would: 

(i) Before January 1, 2013, equal the product of (A) the value-at-risk 

("VaR") estimate for the portfolio as calculated by the bank under the 

existing market risk capital rule and (B) a factor of nine; 

[footnote] 14

 The 9x factor that is applicable prior to January 1, 2013 is intended to reflect a 

value that would be generally equivalent to the market risk measure based on the 

amended market risk rule that is required after year end 2012. [end of footnote.] 

(ii) On and after January 1, 2013, equal the product of (A) the sum of 
(1) the VaR-based measure calculated under section 5 of the amended 

market risk rule and (2) the Stressed VaR-based measure calculated 

under section 6 of that rule, 

[footnote] 15

Risk-Base d Capita l Guidelines: Marke t Ris k , 7 7 F R 5258 7 (August 30 , 2012). [end of footnote

and (B) a factor of three. 

Unless otherwise indicated above, 

[footnote] 16

 As described on page 4, the aggregate absolute value of the negative current 

exposures of all novated derivative contracts or novated derivative netting sets is 

calculated at the time of the novation. [end of footnote.] 

MS Bank would be expected to 

calculate daily the covered transaction amount for all FX derivative transactions 

that have been novated from an individual affiliate and remain outstanding as of 

the end of each day and apply this amount to its quantitative limit for covered 

transactions with a single affiliate under section 23A and Regulation W. Similar 

treatment should be applied for the aggregate affiliate limit under section 23A and 

Regulation W. 

Application of Section 23B to Novated FX Derivative Transactions 

The proposed novation to MS Bank of FX derivative transactions are 

also subject to the market-terms requirement of section 23B of the Federal Reserve 

Act. 

We understand that some of the derivative transactions to be novated 

to MS Bank are expected to have a negative current exposure at the time of the 

novation ("out-of-the-money derivative contracts or derivative netting sets"). We 

would expect, consistent with our understanding of general market practice, that as 

part of the novation to MS Bank by an unaffiliated third party of an out-of-themoney derivative contract or derivative netting set, the bank would receive either 

payment or collateral in an amount at least equal to that negative current exposure. 

Accordingly, consistent with section 23B, MS Bank would be expected to accept a 

novation of an out-of-the-money derivative contract or derivative netting set from 

an affiliate only if MS Bank receives (i) payment from its affiliate, at the time of 

novation, at least equal to any negative current exposure, (ii) all current and future 

rights to qualifying margin or collateral that the bank's affiliate had previously 

posted to the counterparty in an amount at least equal to any negative current 

exposure, or (iii) a combination of payment and rights to posted collateral that fully 

covers the negative current exposure. 
To ensure compliance with the valuation methodology described in 

this letter, MS Bank is expected to submit information to the Federal Reserve Bank 

of New York on a monthly basis that demonstrates how MS Bank valued the FX 

derivative transactions novated to the bank from each individual affiliate, and that 

includes a calculation of the bank's remaining quantitative limit available under 

section 23 A and Regulation W for each individual affiliate and for all affiliates in 

the aggregate. In addition, MS Bank is expected to consult with the Board prior to 

deviating in any way from this methodology in calculating its covered transaction 

amount for novated FX derivative transactions. Once the Board issues a final 

rulemaking modifying Regulation W to incorporate changes made by the 

Dodd-Frank Act, MS Bank must value any derivative contract it novates from an 

affiliate pursuant to the terms of the revised Regulation W, as applicable. 

This opinion is specifically limited to the facts, understandings and 

conditions described in this letter. Any change in these facts or understandings 

could result in a different conclusion and should be reported immediately. If you 

have any questions regarding this letter, please contact Pamela Nardolilli 

(202-452-3289) or Sebastian Astrada (202-452-3594) of the Legal Division, or 

Robert Brooks (202-452-3103) of the Division of Banking Supervision & 

Regulation. 

Sincerely, 

[signed:] Scott G. Alvarez 

cc: Federal Reserve Bank of New York 

Office of the Comptroller of the Currency 

Federal Deposit Insurance Corporation