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  • CA-8 CA-8 Market Risk — Trading Book

    • CA-8.1 CA-8.1 Definition of the Trading Book

      • CA-8.1.1

        The following definition of the trading book replaces the previous definition. Chapters CA-9 to CA-14 deal with market risk rules.

        Apr 08

      • CA-8.1.2

        A trading book consists of positions in financial instruments and commodities held either with trading intent or in order to hedge other elements of the trading book. To be eligible for trading book capital treatment, financial instruments must either be free of any restrictive covenants on their tradability or able to be hedged completely. In addition, positions should be frequently and accurately valued, and the portfolio should be actively managed (at the present time, open equity stakes in hedge funds, private equity investments, positions in a securitisation warehouse and real estate holdings do not meet the definition of the trading book, owing to significant constraints on the ability of banks to liquidate these positions and value them reliably on a daily basis. Such holdings must therefore be held in the bank's banking book and treated as equity holding in corporates, except real estates which should be treated as per CA-3.2.29).

        Amended: January 2012
        Apr 08

      • CA-8.1.3

        A financial instrument is any contract that gives rise to both a financial asset of one entity and a financial liability or equity instrument of another entity. Financial instruments include both primary financial instruments (or cash instruments) and derivative financial instruments. A financial asset is any asset that is cash, the right to receive cash or another financial asset; or the contractual right to exchange financial assets on potentially favourable terms, or an equity instrument. A financial liability is the contractual obligation to deliver cash or another financial asset or to exchange financial liabilities under conditions that are potentially unfavourable.

        Apr 08

      • CA-8.1.4

        Positions held with trading intent are those held intentionally for short-term resale and/or with the intent of benefiting from actual or expected short-term price movements or to lock in arbitrage profits, and may include for example proprietary positions, positions arising from client servicing (e.g. matched principal broking) and market making. It is therefore possible that banks may sometimes not have a trading book as defined above. Nonetheless the bank's strategy and business plan must take account of the requirements of this Chapter in case a bank does take on positions with trading intent.

        Amended: January 2012
        Apr 08

      • CA-8.1.5

        Banks must have clearly defined policies and procedures for determining which exposures to include in, and to exclude from, the trading book for purposes of calculating their regulatory capital, to ensure compliance with the criteria for trading book set forth in this Section and taking into account the bank's risk management capabilities and practices. Compliance with these policies and procedures must be fully documented and subject to periodic internal audit.

        Amended: January 2012
        Apr 08

      • CA-8.1.6

        These policies and procedures must, at a minimum, address the following general considerations:

        (a) The activities the bank considers to be trading and as constituting part of the trading book for regulatory capital purposes;
        (b) The extent to which an exposure can be marked-to-market daily by reference to an active, liquid two-way market;
        (c) For exposures that are marked-to-model, the extent to which the bank can:
        •   Identify the material risks of the exposure;
        •   Hedge the material risks of the exposure and the extent to which hedging instruments would have an active, liquid two-way market;
        •   Derive reliable estimates for the key assumptions and parameters used in the model.
        (d) The extent to which the bank can and is required to generate valuations for the exposure that can be validated externally in a consistent manner;
        (e) The extent to which legal restrictions or other operational requirements would impede the bank's ability to effect an immediate liquidation of the exposure;
        (f) The extent to which the bank is required to, and can, actively risk manage the exposure within its trading operations; and
        (g) The extent to which the bank may transfer risk or exposures between the banking and the trading books and criteria for such transfers.

        The list above is not intended to provide a series of tests that a product or group of related products must pass to be eligible for inclusion in the trading book. Rather, the list provides a minimum set of key points that must be addressed by the policies and procedures for overall management of a firm's trading book.

        Apr 08

      • CA-8.1.7

        The following will be the basic requirements for positions eligible to receive trading book capital treatment:

        (a) Clearly documented trading strategy for the position/instrument or portfolios, approved by senior management (which would include expected holding horizon);
        (b) Clearly defined policies and procedures for the active management of the position, which must include:
        •   Positions are managed on a trading desk;
        •   Position limits are set and monitored for appropriateness;
        •   Dealers have the autonomy to enter into/manage the position within agreed limits and according to the agreed strategy;
        •   Positions are marked to market at least daily and when marking to model the parameters must be assessed on a daily basis;
        •   Positions are reported to senior management as an integral part of the institution's risk management process; and
        •   Positions are actively monitored with reference to market information sources (assessment should be made of the market liquidity or the ability to hedge positions or the portfolio risk profiles). This would include assessing the quality and availability of market inputs to the valuation process, level of market turnover, sizes of positions traded in the market, etc.
        (c) Clearly defined policy and procedures to monitor the positions against the bank's trading strategy including the monitoring of turnover and stale positions in the bank's trading book.
        Amended: April 2011
        Apr 08

      • CA-8.1.8

        When a bank hedges a banking book credit risk exposure using a credit derivative booked in its trading book (i.e. using an internal hedge), the banking book exposure is not deemed to be hedged for capital purposes unless the bank purchases from an eligible third party protection provider a credit derivative meeting the requirements of paragraph CA-4.5.3 vis-à-vis the banking book exposure. Where such third party protection is purchased and is recognised as a hedge of a banking book exposure for regulatory capital purposes, neither the internal nor external credit derivative hedge would be included in the trading book for regulatory capital purposes.

        Apr 08

      • CA-8.1.9

        Term trading-related repo-style transactions that a bank accounts for in its banking book may be included in the bank's trading book for regulatory capital purposes so long as all such repo-style transactions are included. For this purpose, trading-related repo-style transactions are defined as only those that meet the requirements of Paragraphs CA-8.1.4 and CA-8.1.7 and both legs are in the form of either cash or securities includable in the trading book.

        Amended: January 2012
        Apr 08

      • CA-8.1.10

        Regardless of where they are booked, all repo-style transactions are subject to a banking book counterparty credit risk charge.

        Apr 08

      • CA-8.1.11

        For the purposes of this framework, the correlation trading portfolio incorporates securitisation exposures and n-th-to-default credit derivatives that meet the following criteria:

        (a) The positions are neither re-securitisation positions, nor derivatives of securitisation exposures that do not provide a pro-rata share in the proceeds of a securitisation tranche (this therefore excludes options on a securitisation tranche, or a synthetically leveraged super-senior tranche); and
        (b) All reference entities are single-name products, including single-name credit derivatives, for which a liquid two-way market exists. This will include commonly traded indices based on these reference entities. A two-way market is deemed to exist where there are independent bona fide offers to buy and sell so that a price reasonably related to the last sales price or current bona fide competitive bid and offer quotations can be determined within one day and settled at such price within a relatively short time conforming to trade custom.

        Positions which reference an underlying that would be treated as a retail exposure, a residential mortgage exposure or a commercial mortgage exposure under the standardised approach to credit risk are not included in the correlation trading portfolio. Positions which reference a claim on a special purpose entity are not included either. A bank may also include in the correlation trading portfolio positions that hedge the positions described above and which are neither securitisation exposures nor n-th-to-default credit derivatives and where a liquid two-way market as described above exists for the instrument or its underlyings.

        Added: January 2012

    • CA-8.2 CA-8.2 Prudent Valuation Guidance

      [This Chapter has been moved to Chapter CA-16 in January 2012]

      • CA-8.2.1

        This section provides banks with guidance on prudent valuation for positions in the trading book. This guidance is especially important for less liquid positions which, although they will not be excluded from the trading book solely on grounds of lesser liquidity, raise CBB's concerns about prudent valuation.

        Apr 08

      • CA-8.2.2

        A framework for prudent valuation practices should at a minimum include the following:

        Apr 08

      • Systems and Controls

        • CA-8.2.3

          Banks must establish and maintain adequate systems and controls sufficient to give management and CBB the confidence that their valuation estimates are prudent and reliable. These systems must be integrated with other risk management systems within the organisation (such as credit analysis). Such systems must include:

          (a) Documented policies and procedures for the process of valuation. This includes clearly defined responsibilities of the various areas involved in the determination of the valuation, sources of market information and review of their appropriateness, frequency of independent valuation, timing of closing prices, procedures for adjusting valuations, end of the month and ad-hoc verification procedures; and
          (b) Clear and independent (i.e. independent of front office) reporting lines for the department accountable for the valuation process. The reporting line should ultimately be to a main board executive director.
          Apr 08

        • Valuation Methodologies

          • Marking to Market

            • CA-8.2.4

              Marking-to-market is at least the daily valuation of positions at readily available close out prices that are sourced independently. Examples of readily available close out prices include exchange prices, screen prices, or quotes from several independent reputable brokers.

              Apr 08

            • CA-8.2.5

              Banks must mark-to-market as much as possible. The more prudent side of bid/offer must be used unless the institution is a significant market maker in a particular position type and it can close out at mid-market.

              Apr 08

          • Marking to Model

            • CA-8.2.6

              Where marking-to-market is not possible, banks may mark-to-model, where this can be demonstrated to be prudent. Marking-to-model is defined as any valuation which has to be benchmarked, extrapolated or otherwise calculated from a market input.

              Apr 08

            • CA-8.2.7

              When marking to model, an extra degree of conservatism is appropriate. CBB will consider the following in assessing whether a mark-to-model valuation is prudent:

              (a) Senior management should be aware of the elements of the trading book which are subject to mark to model and should understand the materiality of the uncertainty this creates in the reporting of the risk/performance of the business;
              (b) Market inputs should be sourced, to the extent possible, in line with market prices (as discussed above). The appropriateness of the market inputs for the particular position being valued should be reviewed regularly;
              (c) Where available, generally accepted valuation methodologies for particular products should be used as far as possible;
              (d) Where the model is developed by the institution itself, it should be based on appropriate assumptions, which have been assessed and challenged by suitably qualified parties independent of the development process. The model should be developed or approved independently of the front office. It should be independently tested. This includes validating the mathematics, the assumptions and the software implementation;
              (e) There should be formal change control procedures in place and a secure copy of the model should be held and periodically used to check valuations;
              (f) Risk management should be aware of the weaknesses of the models used and how best to reflect those in the valuation output;
              (g) The model should be subject to periodic review to determine the accuracy of its performance (e.g. assessing continued appropriateness of the assumptions, analysis of P&L versus risk factors, comparison of actual close out values to model outputs); and
              (h) Valuation adjustments should be made as appropriate, for example, to cover the uncertainty of the model valuation (see also valuation adjustments in CA-8.2.10 to CA-8.2.13).
              Amended: April 2011
              Apr 08

          • Independent Price Verification

            • CA-8.2.8

              Independent price verification is distinct from daily mark-to-market. It is the process by which market prices or model inputs are regularly verified for accuracy. While daily marking-to-market may be performed by dealers, verification of market prices or model inputs should be performed by a unit independent of the dealing room, at least monthly (or, depending on the nature of the market/trading activity, more frequently). It need not be performed as frequently as daily mark-to-market, since the objective, i.e. independent, marking of positions, should reveal any error or bias in pricing, which should result in the elimination of inaccurate daily marks.

              Apr 08

            • CA-8.2.9

              Independent price verification entails a higher standard of accuracy in that the market prices or model inputs are used to determine profit and loss figures, whereas daily marks are used primarily for management reporting in between reporting dates. For independent price verification, where pricing sources are more subjective, e.g. only one available broker quote, prudent measures such as valuation adjustments may be appropriate.

              Apr 08

      • Valuation Adjustments or Reserves

        • CA-8.2.10

          Banks must establish and maintain procedures for considering valuation adjustments/reserves. CBB expects banks using third-party valuations to consider whether valuation adjustments are necessary. Such considerations are also necessary when marking to model.

          Apr 08

        • CA-8.2.11

          CBB expects the following valuation adjustments/reserves to be formally considered at a minimum: unearned credit spreads, close-out costs, operational risks, early termination, investing and funding costs, and future administrative costs and, where appropriate, model risk.

          Apr 08

        • CA-8.2.12

          Bearing in mind that the underlying 10-day assumption of the market risk rules may not be consistent with the bank's ability to sell or hedge out positions under normal market conditions, banks must make downward valuation adjustments/reserves for these less liquid positions, and to review their continued appropriateness on an on-going basis. Reduced liquidity could arise from market events. Additionally, close-out prices for concentrated positions and/or stale positions should be considered in establishing those valuation adjustments/reserves. Banks must consider all relevant factors when determining the appropriateness of valuation adjustments/reserves for less liquid positions. These factors may include, but are not limited to, the amount of time it would take to hedge out the position/risks within the position, the average volatility of bid/offer spreads, the availability of independent market quotes (number and identity of market makers), the average and volatility of trading volumes, market concentrations, the aging of positions, the extent to which valuation relies on marking-to-model, and the impact of other model risks.

          Apr 08

        • CA-8.2.13

          Valuation adjustments/reserves made under paragraph CA-8.2.12 must impact Tier 2 regulatory capital and may exceed those made under financial accounting standards.

          Apr 08

    • CA-8.3 CA-8.3 Treatment of Counterparty Credit Risk in the Trading Book

      • CA-8.3.1

        Banks must calculate the counterparty credit risk charge for OTC derivatives, repo-style and other transactions booked in the trading book, separate from the capital charge for general market risk and specific risk.62 The risk weights to be used in this calculation must be consistent with those used for calculating the capital requirements in the banking book. Thus, banks applying the standardised approach in the banking book will use the standardised approach risk weights in the trading book and banks applying the IRB approach in the banking book will use the IRB risk weights in the trading book in a manner consistent with the IRB roll out situation in the banking book as described in Paragraphs CA-5.2.28 to CA-5.2.31. For counterparties included in portfolios where the IRB approach is being used the IRB risk weights will have to be applied. The 50% cap on risk weights for OTC derivative transactions is abolished.

        62 The treatment for unsettled foreign exchange and securities trades is set forth in Paragraph CA-3.3.13.

        Amended: January 2012
        Apr 08

      • CA-8.3.2

        In the trading book, for repo-style transactions, all instruments, which are included in the trading book, may be used as eligible collateral. Those instruments which fall outside the banking book definition of eligible collateral shall be subject to a haircut at the level applicable to non-main index equities listed on recognised exchanges (as noted in Paragraph CA-4.3.7. Where banks are applying a VaR approach to measuring exposure for repo-style transactions, they also may apply this approach in the trading book in accordance with Paragraphs CA-4.3.22 to CA-4.3.25 and Appendix CA-2.

        Amended: January 2012
        Apr 08

      • CA-8.3.3

        The calculation of the counterparty credit risk charge for collateralised OTC derivative transactions is the same as the rules prescribed for such transactions booked in the banking book.

        Apr 08

      • CA-8.3.4

        The calculation of the counterparty charge for repo-style transactions will be conducted using the rules in Paragraphs CA-4.3.3 to CA-4.3.25 and Appendix CA-2 spelt out for such transactions booked in the banking book. The firm-size adjustment for SMEs as set out in Paragraph CA-5.3.4 shall also be applicable in the trading book.

        Amended: January 2012
        Apr 08

      • Credit Derivatives

        • CA-8.3.5

          The counterparty credit risk charge for single name credit derivative transactions in the trading book will be calculated applying the following potential future exposure add-on factors:

            Protection buyer Protection seller
          Total Return Swap    
          "Qualifying" reference obligation 5% 5%
          "Non-qualifying" reference obligation 10% 10%
          Credit Default Swap    
          "Qualifying" reference obligation 5% 5%**
          "Non-qualifying" reference obligation 10% 10%**

          There will be no difference depending on residual maturity.

          The definition of "qualifying" is the same as for the "qualifying" category for the treatment of specific risk under the standardised measurement method in chapter CA-9.

          ** The protection seller of a credit default swap shall only be subject to the add-on factor where it is subject to closeout upon the insolvency of the protection buyer while the underlying is still solvent. Add-on should then be capped to the amount of unpaid premiums.

          Apr 08

        • CA-8.3.6

          Where the credit derivative is a first to default transaction, the add-on will be determined by the lowest credit quality underlying in the basket, i.e. if there are any non-qualifying items in the basket, the non-qualifying reference obligation add-on should be used. For second and subsequent to default transactions, underlying assets should continue to be allocated according to the credit quality, i.e. the second lowest credit quality will determine the add-on for a second to default transaction etc.

          Apr 08