Last updated on 6 September 2016
Regulators have seen principles based approach to allocate transactions to a trading or a banking book as a source of capital arbitrage for the banks. Current rules have allowed banks to allocate transactions to trading book largely based on the intent to trade or to hedge. However under FRTB this principles based approach will go away and will be replaced by prescriptive guidelines.
Which financial instruments can be allotted to Trading Book?
- The ones which are managed by a pre-approved Trading desk;
- Instruments which are held for resale in short term, locking-in gains from arbitrage, securities resulting from the underwriting activities and traded to benefit from the price movements in short term. This will generally include cash equities, derivatives including the ones which are packaged with loans and deposits and are bifurcated for accounting purposes and trading related repo-style transactions;
- The instruments which are held in banking book but give rise to net short credit or equity position.
In addition, BCBS rules refer to allotting positions in the correlation trading portfolio to trading book as well.
Which financial instruments cannot be allotted to Trading Book?
- unlisted equities;
- equity investment in fund where daily prices are unavailable;
- instruments designated for securitisation warehousing;
- real estate holdings;
- derivatives which have above as the underlying and
- instruments held for the hedging a risk emanating from above instruments.
What is a Trading Desk?
A new concept around defining trading desk has been introduced in FRTB rules. Key implication is that market risk capital model is approved separately for each trading desk. Trading desk must have:
- set business strategy;
- unambiguously defined trading accounts with a group of traders headed by Head Trader and;
- clear risk management structure including trading mandates, trading limits and risk reporting.
Trading desks are to be approved by supervisors. Questions to think about – how will the trading desk structure under FRTB would differ from the existing Volcker trading desk structure at banks?
Are there any restrictions on switching?
In general, Trading book boundary rules restrict banks to transfer instruments between trading and banking book, specially for the regulatory arbitrage purposes. Switching require approval from senior management as well as regulators. Where capital benefit arises from switching, it will be not recognised. This is achieved by placing a surcharge on the capital equivalent to the difference between initial capital (before the switch) and resulting capital (after the switch). This capital surcharge runs-off as positions mature.
Are any exceptions permitted?
Yes, but subject to the specific approval from the supervisors. Banks will need to provide adequate evidence around how the financial instrument in question does not belong to the trading book category.
So what’s the impact on the business?
These rules will make banks to rethink about the organisational structure of the trading business. For example, should Interest Rate Options (IRO) desk be an independent trading desk or be a part of a broader Rates desk or perhaps Non-Linear Trading desk? In a scenario where IRO desk is part of a Rates desk and the bank chooses to seek internal model approval for Rates desk, it will have to include IRO portfolio in the approval process which could take more time to implement FRTB rules and may have additional complexities with regard to risk modelling, technology infrastructure and capital optimisation. On the contrary, if IRO desk is part of a Non-Linear desk, internal model approach can be used for a Rates Desk only and sensitivities based approach can be used for Non-Linear Desk thereby simplifying the implementation but perhaps at the cost of higher market risk capital charges. This issue is further complicated where a desk may operate in several jurisdictions.
In addition to above, banks will have to consider existing Volcker desk structure when thinking about trading desk structure under FRTB to ensure ongoing compliance with the Volcker rule and the optimal capital outcome.
Banks may have to redesign governance and operational processes to monitor compliance with Trading Book boundary rules as well as provide required reporting to senior management and regulators. For example, more detailed business strategy covering permitted instruments, holding period limits, specific hedging strategies will have to be documented at each trading desk level. This may result in additional resource requirements for Business Management and Operational Risk departments of the bank.
In the next column, I introduce sensitivities based approach (SBA) to calculate market risk capital.