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New FRTB Rules on Risk Factor Eligibility – More Evolution than Revolution

Traders Magazine Online News, January 31, 2019

Kaylash Patel

Small evolutionary changes can lead to significant improvements over time. Last week’s publication  of revised market risk rules as part of the Fundamental Review of the Trading Book (FRTB) from the Basel Committee is a good example when it comes to the Risk Factor Eligibility Test (RFET).

As a reminder, the Risk Factor Eligibility Test will create the operational framework through which financial institutions will decide whether it worth them adopting an internal model under FRTB. 

While banks’ risk teams might not be cracking open the champagne over the scale of the changes, there is reason enough to celebrate. The proposals include four fairly minor changes which combine to increase modellability rates, meaning more institutions may ultimately benefit from an internal model and lower capital costs.

Transparency of “Real” Observations

Banks will be permitted to use either internally executed trade and committed quote data or source this externally. The Basel Committee on Banking Standards (BCBS) has clarified that collateral reconciliation or valuation cannot be considered as a “real” price observation.

Transparency is critical. Banks will need to own the risk factor to “real” price observation mapping process, irrespective of where that data has sourced from. This requirement rules out black box pooled data sources – a significant clarification from the previous version of the rules.  Banks will be able to complement their observation set with “real” observation data from third-parties if the following conditions are met:

  • Provide the dates on which they observe one or more executed trades or committed quotes
  • Provide the instrument T&Cs (i.e. instrument “identifier information to enable banks to map real prices observed to risk factors”
  • Subject to an audit, which is made available on request to the relevant supervisory authority

The onus is on data suppliers to provide sufficient granularity and standardization in their “real” observation data sets. Banks should not be asked to be data aggregators, and will benefit from being able to leverage normalized trade datasets, enriched with reference data required by the market risk teams, consolidated across multiple asset classes and sources.

Using Fixed Income & OTC observations reported under MiFID II 

For banks with European operations, the extensive scope of MiFID II trade data could mean it acts as the pre-eminent source of ‘real’ observation data and significantly reduces the burden of the RFET compliance obligations.

However, one of the challenges of using data which is newly transparent thanks to MiFID II is that many trade reports are deferred for a significant period of time. Research we carried out earlier this year  found that 87 percent of the bonds reported on two popular regulated venues were subject to a maximum deferral length of four weeks or longer. The number was even greater for OTC instruments.

For this consultation, we argued regulators should provide banks with sufficient time to collect data that’s subject to deferred publication prior to conducting RFET.

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