What You Need to Know About the New Trading Boundary

FRTB IS LABELED ‘FUNDAMENTAL’ WITH GOOD REASON; ONE OF THE MOST FUNDAMENTAL CHANGES IS A SIGNIFICANT HARDENING OF THE TRADING BOOK BOUNDARY

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

• FRTB prescribes new tough rules on what activities and instruments can or cannot be classed as trading book
• Definitions have been tightened and new restrictions introduced on transfers and hedges between the trading book and the banking book
• A key new concept is the Regulatory Trading Desk, a standalone unit which will be run by a head trader with its own strategy and risk management structure
• Everything in this new organizational regime, including a strategy document at RTD level, will need to be explicitly documented and approved
• The cost and capital impact of the necessary organisational and other rule changes in the FRTB is estimated to be significant

FRTB framework for trading boundary management

FRTB prescribes a new framework for the segregation of the banking and trading books that involves strict definitions and constraints on movements across the boundary.

This new boundary framework is an important feature of FRTB and represents a major change for many banks’ trading activities. It creates the need for banks to fundamentally rethink how their businesses are organised, controlled, and reported. Business line heads will need to reassess how to maintain their profitability, hedge their risks, and adequately staff their desks. Group business heads, portfolio risk managers, and even market risk managers will face new constraints on their ability to hedge additional capital costs, and will also likely face differing regulatory treatment across jurisdictions.

Highlights of this new framework include:

• Explicit definitions of trading instruments and Regulatory Trading Desks (RTDs)
• Restrictions on movement between books
• Enhanced supervisory powers and reporting requirements
• Granular management and monitoring of risks at the RTD level
• Standardization of internal risk transfer (IRT) treatment across the boundary through the creation of new specialised RTDs

Trading book definition

For an instrument or portfolio to qualify for trading book treatment under FRTB, it will need to pass four strict criteria:

1. It must fit the definition of a trading instrument. This is defined as “a financial instrument, foreign exchange, or commodity trade where there is no legal impediment against selling or fully hedging the instrument.” From a practical standpoint, this definition captures most financial assets unless there is an explicit restriction by an issuer on the sale of the asset (e.g., a revolving credit facility requiring issuer consent prior to sale).
2. It cannot be on the mandatory banking book list, which includes the following instruments:
   • Unlisted equities
   • Warehouse securitisation
   • Fund investments without daily asset transparency
   • Derivatives of any of these assets
   • Real estate holdings
   • Retail and small and medium-sized enterprise (SME) credit, including credit commitments
   • Instruments used to hedge any of these assets
3. Any instrument held for one or more of the purposes listed below must be held in the trading book, subject to supervisory consent:
   • Short-term resale
   • Locking in arbitrage profits
   • Trading listed equities
   • Hedging risks that arise from the above
   • Held for trading assets or liabilities
   • Market-making activities
   • Profiting from short-term price movements
   • Embedded FX risk in banking book
   • Correlation trading
   • Underwriting commitments of securities that are actually expected to be purchased on settlement date (though not loan underwritings)
   • Credit or equity shorts
   • Anything else managed by the RTD
   • Fund investments with daily asset transparency
   • Repo-style trading
   • Options trading, including bifurcated embedded derivatives from the banking book
   • Embedded commodity risk in the banking book

   Banks must receive explicit written approval from their regulator for any deviation from the above, and must track all deviations on an ongoing basis. Notwithstanding this, supervisors reserve the right to require banking or trading book treatment of any instrument other than the ones mandated above.

4. It needs to be managed through a Regulatory Trading Desk (RTD).

The Regulatory Trading Desk

The RTD is a key concept supporting this new paradigm, defined as “a group of traders or trading accounts that implements a well-defined business strategy operating within a clear risk management structure.” FRTB allows for an RTD to have operating sub-desks (OSDs) for internal purposes, as long as the RTD maintains supervisory control over the OSD according to the attributes and reporting procedures described in Table 1 below.

Each RTD needs to be supervised by a head trader who has specific responsibilities and accountabilities under FRTB. Head traders are responsible for developing and implementing a plan for their RTD that sets out all the elements in Table 1. The head trader is responsible for all aspects of this plan, including its approval by senior management and supervisors as well as its implementation and compliance. The head trader will develop a RTD “strategy document,” which is a key new concept that will be covered in detail in a future article.

Table: Attributes and key elements of a Regulatory Trading Desk¹

Attributes

Reporting requirements

Key element 1: Trader or trading account (TTA) Each TTA assigned to only one desk Each TTA is an “indisputable and unambiguous” unit of observation Each desk 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 Head trader’s rules may cut across several businesses, but individual traders may not be head trader of more than one RTD without explicit supervisory approval Each TTA should be assigned to only one RTD, though individual traders may be assigned to up to two RTDs, subject to supervisory approval Supervisors adjudicating requests for traders to service multiple RTDs must be assured that the request supports sound resource allocation needs, and not with an intent to improve the chance of P&L attribution test passage Each TTA must have a clearly defined specialty Each desk must have a clear reporting line to senior management Clear and formal compensation policy linked to pre-established objectives Key element 2: Desks must articulate a well-defined business strategy, including: economics; list of permissible instruments; trading/hedging strategies; clear annual staff budget; and regular MIS covering revenue, costs and RWA. Key element 3: Clear risk management structure Clearly identified risk personnel Well-defined risk limits reviewed annually by senior management including: trader mandates; and desk-level trading limits using appropriate market risk metrics. Appropriate, weekly risk reporting: P&L reports, reviewed by product control; and internal and regulatory desk-level risk reports, including VaR/ES, sensitivities, p-value and backtesting. Key element 4: Each regulatory desk is proposed by the bank, but approved by the supervisor: bank proposal to address elements 1–3 above supervisors adjudicate based on relative size of desk to trading operations as well as elements 1–3 above.

Inventory ageing reports Daily limit reports, including: exposures; limit breaches; and follow-up action. Intraday reports, including: utilisation versus limits; and breaches versus limits. Market liquidity assessments Reports required under elements 2–3 to the left FX and commodity risks held in the banking book must be included in the market risk charges, and treated as if held on notional trading desks within the trading book for regulatory capital calculation Robust exception reporting for all of the above complete with appropriate escalation, adjudication and remediation procedures

The RTD strategy document will contain a list of instruments that the RTD is allowed to trade. Any deviation from this list will require supervisory approval before being officially included.

Trading instruments will be defined by segregated risk factors and by liquidity horizons (LHs) extending up to 120 days. Some of these risk factors may be deemed to be non-modelable risk factors (NMRFs) if they have insufficient trading history. Others will be defined as banking book instruments at the outset. Default risk will be captured separately through a new Default Risk Charge (DRC) in both the standardized and IMA approaches, and certain instruments will be strictly defined as existing only on one side of the boundary or another.

Old and new concepts

In summary, the FRTB involves a meaningful reorganization of the trading book/banking book boundary, with a redefinition of some existing concepts and the creation of several new ones.

Table 2: New and redefined trading book boundary concepts

New concepts	Old concepts redefined
Regulatory trading desk (RTD) Operating sub-desks (OSD) Internal risk transfer desk Liquidity horizons (LHs) Non-modellable risk factors (NMRFs) P&L attribution (PLA) Equity jump-to-default (EJTD) Instrument illiquidity Actionable and observable prices	Trading book Trading instruments Trading purpose Mandatory banking book Mandatory trading book Granular regulation and SA application Embedded trading risks in the banking book: commodity risk (CRBB) FX risk (FXRBB) interest rate risk (IRRBB)

Estimated impact

The impact of the new boundary restrictions, alongside the other changes required under the FRTB, is expected to be significant, including on capital costs. Based on the first four Quantitative Impact Studies (QIS) which were run alongside the FRTB while it was being developed, the FRTB will result in a 40% weighted average increase in required market risk capital. Meanwhile certain business lines, notably securitization and correlation trading, will be even more severely impacted. Despite the likely further recalibration of the standardized method, these estimates may even prove low for banks currently using advanced approach methodologies if there is a more widespread shift to using standardized method, which at the time of writing seems a likely outcome.

Compliance and IT costs will increase dramatically to address the numerous new requirements. The co-ordination of trading and banking functions within businesses will require different reporting regimes, while business lines such as debt capital markets, high-yield loan origination, and corporate banking will find it extremely difficult to align with trading desks without a raft of new reports. Calculation, reporting, and monitoring of standardized calculations (in addition to IMA where required) will be an additional burden. This will be true even for IMA banks, which will need to keep the standardized calculations running for comparative purposes as an ongoing condition of IMA approval. This is to ensure capital floor conditions can be met and to ensure clear sight of the capital impact of losing IMA approval at any time. Furthermore, additional computing power will be required to accommodate increasingly complex trading algorithms.

The necessary changes in the organizational structure will also have a material impact on costs and capital. Banks will need to weigh increased operating and compliance costs of multiple desks against the increased capital costs of having fewer desks. They may also need to weigh the impact of different jurisdictional interpretations of FRTB boundary rules in the management of illiquid businesses under banking or trading books. Hedging will be more challenging, particularly across the newly defined boundary. Banks will have to navigate new limitations on hedging banking book assets with trading products; likewise, there will also be new limitations on hedging trading products. Finally, the benefits of natural within-portfolio correlation will be muted, with new limitations on netting and stricter interpretation of basis risks.

Finally, more granular compliance at the trading desk level will also need to include management of boundary movements. All in all, the cost impact of FRTB is expected to be very significant, and the revised rules on the trading boundary form an important part of that reckoning.