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  • CA-12 CA-12 Market Risk — Commodities Risk — (STA)

    • CA-12.1 CA-12.1 Introduction

      • CA-12.1.1

        This Chapter sets out the minimum capital requirements to cover the risk of holding or taking positions in commodities, including precious metals, but excluding gold (which is treated as a foreign currency according to the methodology explained in Chapter CA-11).

        January 2015

      • CA-12.1.2

        The commodities position risk and the capital charges are calculated with reference to the entire business of a conventional bank licensee, i.e., the banking and trading books combined.

        January 2015

      • CA-12.1.3

        The price risk in commodities is often more complex and volatile than that associated with currencies and interest rates. Commodity markets may also be less liquid than those for interest rates and currencies and, as a result, changes in supply and demand can have a more dramatic effect on price and volatility. Conventional bank licensees need also to guard against the risk that arises when a short position falls due before the long position. Owing to a shortage of liquidity in some markets, it might be difficult to close the short position and the conventional bank licensee might be "squeezed by the market". All these market characteristics, of commodities, can make price transparency and the effective hedging of risks more difficult.

        January 2015

      • CA-12.1.4

        For spot or physical trading, the directional risk arising from a change in the spot price is the most important risk. However, conventional bank licensees applying portfolio strategies involving forward and derivative contracts are exposed to a variety of additional risks, which may well be larger than the risk of a change in spot prices (directional risk). These include:

        (a) 'Basis risk', i.e., the risk that the relationship between the prices of similar commodities alters through time;
        (b) 'Interest rate risk', i.e., the risk of a change in the cost of carry for forward positions and options; and
        (c) 'Forward gap risk', i.e., the risk that the forward price may change for reasons other than a change in interest rates.
        January 2015

      • CA-12.1.5

        The capital charges for commodities risk envisaged by the rules within this Chapter are intended to cover the risks identified in Paragraph CA-12.1.4. In addition, however, conventional bank licensees face credit counterparty risk on over-the-counter derivatives, which must be incorporated into their credit risk capital requirements. Furthermore, the funding of commodities positions may well open a conventional bank licensee to interest rate or foreign exchange risk which is captured within the measurement framework set out in Chapters CA-9 and CA-11, respectively.49

        49 Where a commodity is part of a forward contract (i.e.. a quantity of commodity to be received or to be delivered), any interest rate or foreign exchange risk from the other leg of the contract must be captured, within the measurement framework set out in Chapters CA-9 and CA-11, respectively. However, positions which are purely of a stock financing nature (i.e., a physical stock has been sold forward and the cost of funding has been locked in until the date of the forward sale) may be omitted from the commodities risk-calculation although they will be subject to the interest rate and counterparty risk capital requirements.

        January 2015

      • CA-12.1.6

        Conventional bank licensees which have the intention and capability to use internal models for the measurement of their commodities risks and, hence, for the calculation of the capital requirement, must seek the prior written approval of the CBB for those models. The CBB's detailed rules for the recognition and use of internal models are included in Chapter CA-14. It is essential that the internal models methodology captures the directional risk, forward gap and interest rate risks, and the basis risk which are defined in Paragraph CA-12.1.4. It is also particularly important that models take proper account of market characteristics, notably the delivery dates and the scope provided to traders to close out positions.

        January 2015

      • CA-12.1.7

        Conventional bank licensees which do not propose to use internal models must adopt either the maturity ladder approach or the simplified approach to calculate their commodities risk and the resultant capital charges. Both these approaches are described in Sections CA-12.3 and CA-12.4, respectively.

        January 2015

    • CA-12.2 CA-12.2 Calculation of Commodities Positions

      • Netting

        • CA-12.2.1

          Conventional bank licensees must first express each commodity position (spot plus forward) in terms of the standard unit of measurement (i.e., barrels, kilograms, grams etc.). Long and short positions in a commodity are reported on a net basis for the purpose of calculating the net open position in that commodity. For markets which have daily delivery dates, any contracts maturing within ten days of one another may be offset. The net position in each commodity is then converted, at spot rates, into the conventional bank licensee's reporting currency.

          January 2015

        • CA-12.2.2

          Positions in different commodities cannot be offset for the purpose of calculating the open positions as described in Paragraph CA-12.2.1 above. However, where two or more sub-categories50 of the same category are, in effect, deliverable against each other, netting between those sub-categories is permitted. Furthermore, if two or more sub-categories of the same category are considered as close substitutes for each other, and minimum correlation of 0.9 between their price movements is clearly established over a minimum period of one year, the conventional bank licensee may, with the prior written approval of the CBB, net positions in those sub-categories. Conventional bank licensees which wish to net positions based on correlations, in the manner discussed above, must satisfy the CBB of the accuracy of the method which it proposes to adopt.

          50 Commodities can be grouped into clans, families, sub-groups and individual commodities. For example, a clan might be Energy Commodities, within which Hydro-Carbons is a family with Crude Oil being a sub-group and West Texas Intermediate, Arabian Light and Brent being individual commodities.

          January 2015

      • Derivatives

        • CA-12.2.3

          All commodity derivatives and off-balance-sheet positions which are affected by changes in commodity prices must be included in the measurement framework for commodities risks. This includes commodity futures, commodity swaps, and options where the "delta plus" method is used51. In order to calculate the risks, commodity derivatives are converted into notional commodities positions and assigned to maturities as follows:

          (a) Futures and forward contracts relating to individual commodities must be incorporated in the measurement framework as notional amounts of barrels, kilograms etc., and must be assigned a maturity with reference to their expiry date;
          (b) Commodity swaps where one leg is a fixed price and the other one is the current market price, must be incorporated as a series of positions equal to the notional amount of the contract, with one position corresponding to each payment on the swap and slotted into the maturity time-bands accordingly. The positions would be long positions if the conventional bank licensee is paying fixed and receiving floating, and short positions if vice versa. (If one of the legs involves receiving/paying a fixed or floating interest rate, that exposure must be slotted into the appropriate repricing maturity band for the calculation of the interest rate risk, as described in Chapter CA-9); and
          (c) Commodity swaps where the legs are in different commodities must be incorporated in the measurement framework of the respective commodities separately, without any offsetting. Offsetting will only be permitted if the conditions set out in Paragraphs CA-12.2.1 and CA-12.2.2 are met.

          51 For banks applying other approaches to measure options risks, all Options and the associated underlying instruments must be excluded from both the maturity ladder approach and the simplified approach. The treatment of options is described, in detail, in Chapter CA-13.

          January 2015

    • CA-12.3 CA-12.3 Maturity Ladder Approach

      • CA-12.3.1

        A worked example of the maturity ladder approach is set out in Appendix CA-13 and the table in Paragraph CA-12.3.2 illustrates the maturity time-bands of the maturity ladder for each commodity.

        January 2015

      • CA-12.3.2

        The steps in the calculation of the commodities risk by the maturity ladder approach are:

        (a) The net positions in individual commodities, expressed in terms of the standard unit of measurement, are first slotted into the maturity ladder. Physical stocks are allocated to the first time-band. A separate maturity ladder is used for each commodity as defined in Section CA-12.2 earlier in this Chapter. The net positions in commodities are calculated as explained in Section CA-12.2;
        (b) Long and short positions in each time-band are matched. The sum of the matched long and short positions is multiplied first by the spot price of the commodity, and then by a spread rate of 1.5% for each time-band as set out in the table below. This represents the capital charge in order to capture forward gap and interest rate risk within a time-band (which, together, are sometimes referred to as curvature/spread risk);

        Time-bands52
        0 – 1 months
        1 – 3 months
        3 – 6 months
        6 – 12 months
        1 – 2 years
        2 – 3 years
        over 3 years
        (c) The residual (unmatched) net positions from nearer time-bands are then carried forward to offset opposite positions (i.e. long against short, and vice versa) in time-bands that are further out. However, a surcharge of 0.6% of the net position carried forward is added in respect of each time-band that the net position is carried forward, to recognise that such hedging of positions between different time-bands is imprecise. The surcharge is in addition to the capital charge for each matched amount created by carrying net positions forward, and is calculated as explained in step (b) above; and
        (d) At the end of step (c) above, there will be either only long or only short positions, to which a capital charge of 15% applies. The CBB recognises that there are differences in volatility between different commodities, but has, nevertheless, decided that one uniform capital charge for open positions in all commodities apply in the interest of simplicity of the measurement, and given the fact that conventional bank licensees normally run rather small open positions in commodities. Conventional bank licensees must submit, in writing, details of their commodities business, to enable the CBB to evaluate whether the models approach should be adopted by the conventional bank licensee, to capture the market risk on this business.

        52 For instruments, the maturity of which is on the boundary of two maturity time-bands, the instrument must be placed into the earlier maturity band. For example, instruments with a maturity of exactly one year are placed into the 6 to 12 months time-band.

        January 2015

    • CA-12.4 CA-12.4 Simplified Approach

      • CA-12.4.1

        By the simplified approach, the capital charge of 15% of the net position, long or short, in each commodity is applied to capture directional risk. Net positions in commodities are calculated as explained in Section CA-12.2.

        January 2015

      • CA-12.4.2

        An additional capital charge equivalent to 3% of the conventional bank licensee's gross positions, long plus short, in each commodity is applied to protect the conventional bank licensee against basis risk, interest rate risk and forward gap risk. In valuing the gross positions in commodity derivatives for this purpose, conventional bank licensees must use the current spot price.

        January 2015