How an RTD Strategy Document Can Make or Break Trading Desk Profitability

A STRONG, TRANSPARENT STRATEGY DOCUMENT WILL SIGNAL TO SUPERVISORS THAT A REGULATORY TRADING DESK IS WELL-MANAGED—OR THE OPPOSITE

By: Sanjay Sharma, John Beckwith
Edited by: Howard Walwyn

A granular, dynamic strategy document for each Regulatory Trading Desk is a critical requirement under the FRTB
This document will need to set out not only operating parameters like reporting lines and trader authorities, but also risk limit information and compensation policy at desk level
It will represent the first line of sight for auditors and supervisors looking for evidence that the desk head is fulfilling their FRTB management responsibilities
In some banks this kind of strategy document has not traditionally been an area of focus for desk heads and traders
The costs of failure to produce a comprehensive, rigorous RTD strategy document could be damaging and wide-ranging for both business and risk management

Recap on Regulatory Trading Desk

In this article here, we described the significant revisions in the FRTB pertaining to the trading book boundary. The definitions of what activities and instruments can or must go in either the trading book or the banking book are significantly tightened, and strict restrictions placed on the movement of positions between them.

Also in that article we introduced the FRTB concept of the Regulatory Trading Desk, a new standalone business unit, which is managed by a head trader and which will be, among other things, the business level at which internal model approval (IMA) will be sought and approved—or, if not approved, the RTD will be the level at which it is relegated to standardised approach treatment.

There are four key elements to the RTD, alongside a number of enhanced reporting requirements:

It must consist of a number of component Traders or Trading Accounts (TTA), each of which is an “indisputable and unambiguous” unit of observation.
It must have a clear and clear well-defined risk management structure as a standalone entity.
Although proposed by the bank, the supervisor has the final say in whether the proposed RTD structure is acceptable.
It must articulate a well-defined business strategy including economics, a list of permissible instruments, trading/hedging strategies, a clear annual staff budget and regular management information covering revenue, costs, and RWA.

RTD strategy document

As set out in our earlier article, head traders are responsible for developing and implementing a plan for their RTD which addresses all these elements. This plan is known as the RTD strategy document, and will serve as the primary source of record pertaining to the RTD, including for auditors and supervisors who are tasked with examining the performance and compliance with required standards over time. The RTD head trader will need to give careful consideration to how the permissible instruments list is defined, since any deviation from this list will require supervisory approval prior to inclusion.

Desk supervision and reporting lines

Other elements that will need to be recorded in the RTD strategy document are the desk supervisory arrangements and reporting lines; each RTD must have no more than two head traders with direct oversight over all TTAs. In the event that an RTD has two head traders, either one must report to the other, or there must be clearly separated rules, responsibilities, and authorities set out in the RTD strategy document. A head trader’s authorities may cut across several businesses, but individual traders may not be head trader of more than one RTD without explicit supervisory approval. Reporting lines from the head trader up to senior management must also be clearly set out.

Similarly, each TTA must have a clearly defined specialty and should be assigned to only one RTD (although individual traders may be assigned to up to two RTDs, subject to supervisory approval). Supervisors adjudicating requests for traders to service multiple RTDs will need to be reassured that the request is sound on resource allocation grounds, and is not merely an effort to improve the RTD’s chances of passing critical supervisory tests (such as the P&L attribution test).

Risk management and compensation

The requirement for a clear risk management structure means that the RTD strategy document must clearly identify relevant risk personnel for the RTD. As such, it should also be the official repository for well-defined risk limits and trader mandates at the RTD level, all which should be reviewed annually by senior management. Reporting requirements around P&L (reviewed by product control) and internal/regulatory desk-level risk reports (including VaR/ES, sensitivities, p-values and backtesting outcomes) should also be specified.

Finally, and perhaps most controversially, the RTD must have a clear and formal compensation policy linked to pre-established business objectives.

The previous discussion should make it evident how granular and operational the RTD strategy document needs to be; it is by no means a one-off document that gets completed, looked at once, approved, and then put on a shelf to gather dust. It needs to be a living, breathing document that is continuously updated to reflect changes in business, personnel, hedging approach, and risk profile.

Case studies

It is to be expected that many people working on trading desks and support functions will be sceptical about documenting hard-to-define things like business strategy and hedging approach; perhaps the assumption is that the documentation of it will somehow demystify or devalue the activity, to the point where perhaps the traders’ skills aren’t needed any more, or no longer justify the compensation being paid to them.

As we will see in the following case studies, the role of Head Trader will become even more fundamental to bank trading frameworks. The following extracts, taken from The FRTB: Concepts, Implications and Implementation (Sharma and Beckwith, 2018, pages 44-47), set out some hypothetical examples to illustrate how seemingly simple decisions about what is in the RTD—and what it is and is not permitted to do—will now have a big impact on profitability and even risk.

Case A: Electronic equities

Bank X wants to establish a global desk for trading equities over an electronic platform. The strategy of this desk will differ from the bank’s traditional sales/trader platform in its economics (lower margin, higher volume), permissible instruments (higher liquidity standards), and intraday limits. To comply with FRTB, Bank X will need to establish a global desk reporting to a head trader who is independent from the traditional equity trading desk and has direct oversight over all TTAs, reporting, and management information systems for that desk. The desk may establish operating sub-desks in different geographies, but only if all relevant supervisors agree that the strategy will be deployed consistently across geographies and in compliance with all aspects of the RTD requirements.

What’s the cost? If they do not agree, the OSDs will not be approved as part of the global RTD, which could affect both profitability and hedging efficiency for the global book. The RTD strategy document in this case will be critically important in demonstrating to the supervisors that the desk is run globally and properly controlled by the head trader.

Case B: Legacy trading assets

Bank Y has traditionally managed its less-liquid trading assets through a “non-core” desk. These assets include positions in small bond issues, a small number of insurance-linked securities, and some thinly traded distressed loans. Instruments transferred from other internal trading desks are done so at market and on an arm’s length basis. The mandate of the desk is clear (reduce exposures as quickly as possible within prescribed time constraints) and the total position relative to Bank Y’s book is capped at 2%. Bank Y wants to ensure that these sensitive positions have senior oversight, and so it maintains a separate management team for the desk with a head trader reporting independently to senior management on a weekly basis. Despite the seemingly diverse set of instruments, Bank Y’s supervisor may approve this as a single RTD under FRTB if it is convinced that the strategy is consistent, well-managed, and transparent.

What’s the cost? If the supervisor is not convinced by the strategy, the wide range of legacy instruments in the non-core book will need to be dispersed across other trading desks in a fragmented fashion, with the result that no single individual has oversight over them; this leads to an increased likelihood of the positions being neglected, mispriced, or simply forgotten about by traders, product control, and risk management alike. In this case the unified desk strategy is clearly supporting good risk management, but unless the RTD strategy document is comprehensive and transparent about how the legacy positions are managed, the supervisor may be sceptical about the degree of breadth and variety of positions within individual TTAs, and may not be minded to approve it. This would be a bad outcome, potentially for the supervisor as well as the desk. The RTD strategy document is a critical tool to facilitate the right outcome all round.

Case C: Covered bonds

Bank Z believes its covered bond program delivers a competitive advantage by taking issuers in multiple jurisdictions to a broad investor base around the globe; however, the dynamics of covered bond markets can vary substantially between geographies based on differing enabling legislation, depth of markets, and various regulatory proscriptions. Under the FRTB, Bank Z will likely need to establish separate RTDs for each issuer jurisdiction with separate risk strategies based on local market depth, current and pending legislation, and local regulation. Sales and debt capital markets (DCM) desks operating in various jurisdictions will interact with the trading desk (or operating sub-desk) controlling specific issuance products.

What’s the cost? If the RTD strategy document at each geographic level is not sufficiently clear and persuasive, that geographical unit will not be approved as an RTD. This will directly affect the profitability outcome for the bank.

Documentation matters

Under the FRTB documentation matters, more than ever, for business heads and other front office personnel—many of whom may have paid little attention to it in the past. The need includes traditionally difficult areas to define such as trading mandates, high-level business strategy, and even the intra-day hedging approach. But the fact that something is difficult to define is not going to be accepted as an explanation for a poorly conceived, unstructured, out-of date, or badly executed RTD strategy document. If it is any of those things, the cost could be significant for the RTD.