The Capital Adequacy Requirements (CAR) for banks, bank holding companies, and trust and loan companies, collectively referred to as ‘institutions’, are set out in nine chapters, each of which has been issued as a separate document. This document, Chapter 9 – Market Risk, should be read in conjunction with the other CAR chapters which include:
This section provides a high-level description of terminologies used in the market risk frameworks.
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Market risk: the risk of losses in on- and off-balance sheet risk positions arising from movements in market prices. [Basel Framework, MAR10.1]
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Notional value: the notional value of a derivative instrument is equal to the number of units underlying the instrument multiplied by the current market value of each unit of the underlying. [Basel Framework, MAR10.2]
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Trading desk: a group of traders or trading accounts in a business line within an institution that follows defined trading strategies with the goal of generating revenues or maintaining market presence from assuming and managing risk. [Basel Framework, MAR10.3]
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Pricing model: a model that is used to determine the value of an instrument (mark-to-market or mark-to-model) as a function of pricing parameters or to determine the change in the value of an instrument as a function of risk factors. A pricing model may be the combination of several calculations; e.g. a first valuation technique to compute a price, followed by valuation adjustments for risks that are not incorporated in the first step. [Basel Framework, MAR10.4]
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Rating Agencies: OSFI conducted a process to determine which of the major international rating agencies would be recognized as an eligible external credit assessment institution under this chapter. As a result of this process, OSFI will permit institutions to recognize credit ratings from the following rating agencies for market risk capital adequacy purposes: DBRS; Moody’s Investor Service; Standard and Poor’s (S&P); Fitch Rating Services and; Kroll Bond Rating Agency, Inc.
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Risk factor: a principal determinant of the change in value of an instrument (e.g. an exchange rate or interest rate). [Basel Framework, MAR10.9]
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Risk position: the portion of the current value of an instrument that may be subject to losses due to movements in a risk factor. For example, a bond denominated in a currency different to an institution’s reporting currency has risk positions in general interest rate risk, credit spread risk (non-securitization) and FX risk, where the risk positions are the potential losses to the current value of the instrument that could occur due to a change in the relevant underlying risk factors (interest rates, credit spreads, or exchange rates). [Basel Framework, MAR10.10]
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Risk bucket: a defined group of risk factors with similar characteristics. [Basel Framework, MAR10.11]
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Risk class: a defined list of risks that are used as the basis for calculating market risk capital requirements: general interest rate risk, credit spread risk (non-securitization), credit spread risk (securitization: non-correlation trading portfolio), credit spread risk (securitization: correlation trading portfolio), FX risk, equity risk and commodity risk. [Basel Framework, MAR10.12]
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Sensitivity: an institution’s estimate of the change in value of an instrument due to a small change in one of its underlying risk factors. Delta and vega risks are sensitivities. [Basel Framework, MAR10.13]
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Delta risk: the linear estimate of the change in value of a financial instrument due to a movement in the value of a risk factor. The risk factor could be the price of an equity or commodity, or a change in an interest rate, credit spread or FX rate. [Basel Framework, MAR10.14]
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Vega risk: the potential loss resulting from the change in value of a derivative due to a change in the implied volatility of its underlying. [Basel Framework, MAR10.15]
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Curvature risk: the additional potential loss beyond delta risk due to a change in a risk factor for financial instruments with optionality. In the standardized approach in the market risk framework, it is based on two stress scenarios involving an upward shock and a downward shock to each regulatory risk factor. [Basel Framework, MAR10.16]
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Value at risk (VaR): a measure of the worst expected loss on a portfolio of instruments resulting from market movements over a given time horizon and a pre-defined confidence level. [Basel Framework, MAR10.17]
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Expected shortfall (ES): a measure of the average of all potential losses exceeding the VaR at a given confidence level. [Basel Framework, MAR10.18]
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Jump-to-default (JTD): the risk of a sudden default. JTD exposure refers to the loss that could be incurred from a JTD event. [Basel Framework, MAR10.19]
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Liquidity horizon: the time assumed to be required to exit or hedge a risk position without materially affecting market prices in stressed market conditions. [Basel Framework, MAR10.20]
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Basis risk: the risk that prices of financial instruments in a hedging strategy are imperfectly correlated, reducing the effectiveness of the hedging strategy. [Basel Framework, MAR10.21]
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Diversification: the reduction in risk at a portfolio level due to holding risk positions in different instruments that are not perfectly correlated with one another. [Basel Framework, MAR10.22]
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Hedge: the process of counterbalancing risks from exposures to long and short risk positions in correlated instruments. [Basel Framework, MAR10.23]
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Offset: the process of netting exposures to long and short risk positions in the same risk factor. [Basel Framework, MAR10.24]
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Standalone: being capitalised on a stand-alone basis means that risk positions are booked in a discrete, non-diversifiable trading book portfolio so that the risk associated with those risk positions cannot diversify, hedge or offset risk arising from other risk positions, nor be diversified, hedged or offset by them. [Basel Framework, MAR10.25]
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Backtesting: the process of comparing daily actual and hypothetical profits and losses with model-generated VaR measures to assess the conservatism of risk measurement systems. [Basel Framework, MAR10.28]
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Profit and loss (P&L) attribution (PLA): a method for assessing the robustness of institutions’ risk management models by comparing the risk-theoretical P&L predicted by trading desk risk management models with the hypothetical P&L. [Basel Framework, MAR10.29]
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Trading desk risk management model: the trading desk risk management model (pertaining to in-scope desks) includes all risk factors that are included in the institution’s ES model with OSFI parameters and any risk factors deemed not modellable, which are therefore not included in the ES model for calculating the respective regulatory capital requirement, but are included in NMRFs. [Basel Framework, MAR10.30]
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Actual P&L (APL): the actual P&L derived from the daily P&L process. It includes intraday trading as well as time effects and new and modified deals, but excludes fees and commissions as well as valuation adjustments for which separate regulatory capital approaches have been otherwise specified as part of the rules or which are deducted from Common Equity Tier 1 (CET1). Any other valuation adjustments that are market risk-related must be included in the APL. As is the case for the hypothetical P&L, the APL should include FX and commodity risks from positions held in the banking book. [Basel Framework, MAR10.31]
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Hypothetical P&L (HPL): the daily P&L produced by revaluing the positions held at the end of the previous day using the market data at the end of the current day. Commissions, fees, intraday trading and new/modified deals, valuation adjustments for which separate regulatory capital approaches have been otherwise specified as part of the rules and valuation adjustments which are deducted from CET1 are excluded from the HPL. Valuation adjustments updated daily should usually be included in the HPL. Time effects should be treated in a consistent manner in the HPL and risk-theoretical P&L. [Basel Framework, MAR10.32]
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Risk-theoretical P&L (RTPL): the daily desk-level P&L that is predicted by the valuation engines in the trading desk risk management model using all risk factors used in the trading desk risk management model (i.e. including the NMRFs). [Basel Framework, MAR10.33]
This section defines the methods available for calculating and the scope of application of market risk capital requirements.
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Market risk is defined as the risk of losses arising from movements in market prices. The risks subject to market risk capital requirements include but are not limited to:
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default risk, interest rate risk, credit spread risk, equity risk, foreign exchange (FX) risk and commodities risk for trading book instruments; and
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FX risk and commodities risk for banking book instruments.
[Basel Framework, MAR11.1]
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Derivative, repurchase/reverse repurchase, securities lending and other transactions booked in the trading book are subject to both the market risk and the counterparty credit risk capital requirements. This is because they face the risk of loss due to market fluctuations in the value of the underlying instrument and due to the failure of the counterparty to the contract. The counterparty risk weights used to calculate the credit risk capital requirements for these transactions are those used for calculating the capital requirements in the banking book.
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All transactions, including forward sales and purchases, shall be included in the calculation of capital requirements as of the date on which they were entered into. Although regular reporting will in principle take place only at intervals (quarterly in most countries), institutions are expected to manage their market risk in such a way that the capital requirements are being met on a continuous basis, including at the close of each business day. OSFI has at its disposal a number of effective measures to ensure that institutions do not window-dress by showing significantly lower market risk positions on reporting dates. Institutions will also be expected to maintain strict risk management systems to ensure that intraday exposures are not excessive. If an institution fails to meet the capital requirements at any time, OSFI shall ensure that the institution takes immediate measures to rectify the situation. [Basel Framework, MAR11.2]
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A matched currency risk position will protect an institution against loss from movements in exchange rates, but will not necessarily protect its capital adequacy ratio. If an institution has its capital denominated in its domestic currency and has a portfolio of foreign currency assets and liabilities that is completely matched, its capital/asset ratio will fall if the domestic currency depreciates. By running a short risk position in the domestic currency, the institution can protect its capital adequacy ratio, although the risk position would lead to a loss if the domestic currency were to appreciate. OSFI will allow institutions to protect their capital adequacy ratio in this way and exclude certain currency risk positions from the calculation of net open currency risk positions, subject to meeting each of the following conditions:
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The risk position is taken or maintained for the purpose of hedging partially or totally against the potential that changes in exchange rates could have an adverse effect on its capital ratio.
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The risk position is of a structural (i.e. non-dealing) nature such as positions stemming from:
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investments in affiliated but not consolidated entities denominated in foreign currencies; or
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investments in consolidated subsidiaries or branches denominated in foreign currencies.
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The exclusion is limited to the amount of the risk position that neutralizes the sensitivity of the capital ratio to movements in exchange rates.
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The exclusion from the calculation is made for at least six months.
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The establishment of a structural FX position and any changes in its position must follow the institution’s risk management policy for structural FX positions. This policy must be pre-approved by OSFI.
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Any exclusion of the risk position needs to be applied consistently, with the exclusionary treatment of the hedge remaining in place for the life of the assets or other items.
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The institution must document and have available for OSFI review the positions and amounts to be excluded from market risk capital requirements.
[Basel Framework, MAR11.3]
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No FX risk capital requirement will apply to positions related to items that are deducted from an institution’s capital when calculating its capital base. [Basel Framework, MAR11.4]
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Holdings of capital instruments that are deducted from an institution’s capital or risk weighted at 1250% are not allowed to be included in the market risk framework. This includes:
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holdings of the institution’s own eligible regulatory capital instruments and, if applicable, own Other TLAC Instruments; and
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holdings of other institutions’, securities firms’ and other financial entities’ eligible regulatory capital instruments and in G-SIBs’ or D-SIBs’ Other TLAC Instruments, as well as intangible assets, where OSFI requires that such assets are deducted from capital.
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Where an institution demonstrates that it is an active market-maker, OSFI may establish a dealer exception for holdings of other institutions’, securities firms’, and other financial entities’ capital instruments in the trading book. In order to qualify for the dealer exception, the institution must have adequate systems and controls surrounding the trading of financial institutions’ eligible regulatory capital instruments and Other TLAC Instruments.
[Basel Framework, MAR11.5]
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This dealer exception applies only to positions in another institution’s regulatory capital instruments and/or Other TLAC Instruments that do not exceed the 10% threshold or the 5% threshold on non-significant investments described in Chapter 2 – Definition of Capital, section 2.3. For the capital treatment of significant investments in capital and Other TLAC Instruments of banks, financial and insurance entities refer to Chapter 2 – Definition of Capital, section 2.3.
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In the same way as for credit risk and operational risk, the capital requirements for market risk apply on a worldwide consolidated basis.
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OSFI may permit banking and financial entities in a group which is running a global consolidated trading book and whose capital is being assessed on a global basis to include just the net short and net long risk positions no matter where they are booked.
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OSFI may grant this treatment only when the standardized approach in section 9.5 permits a full offset of the risk position (i.e. risk positions of the opposite sign do not attract a capital requirement).
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Nonetheless, there will be circumstances in which OSFI demands that the individual risk positions be taken into the measurement system without any offsetting or netting against risk positions in the remainder of the group. This may be needed, for example, where there are obstacles to the quick repatriation of profits from a foreign subsidiary or where there are legal and procedural difficulties in carrying out the timely management of risks on a consolidated basis.
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Moreover, OSFI will retain the right to continue to monitor the market risks of individual entities on a non-consolidated basis to ensure that significant imbalances within a group do not escape supervision. OSFI will be especially vigilant in ensuring that institutions do not conceal risk positions on reporting dates in such a way as to escape measurement.
[Basel Framework, MAR11.6]
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In determining its market risk for regulatory capital requirements, an institution may choose between two broad methodologies: the standardized approach and internal models approach (IMA) for market risk, described in section 9.5 and section 9.6, respectively, subject to the approval of OSFI. [Basel Framework, MAR11.7]
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All institutions must calculate the capital requirements using the standardized approach. Institutions that are approved by OSFI to use the IMA for market risk capital requirements must also calculate and report the capital requirement values calculated as set out below.
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An institution that uses the IMA for any of its trading desks must also calculate the capital requirement under the standardized approach for all instruments across all trading desks, regardless of whether those trading desks are eligible for the IMA.
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In addition, an institution that uses the IMA for any of its trading desks must calculate the standardized approach capital requirement for each trading desk that is eligible for the IMA as if that trading desk were a standalone regulatory portfolio (i.e. with no offsetting across trading desks). This will:
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serve as an indication of the fallback capital requirement for those desks that fail the eligibility criteria for inclusion in the institution’s internal model as outlined in section 9.6;
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generate information on the capital outcomes of the internal models relative to a consistent benchmark and facilitate comparison in implementation between institutions and/or across jurisdictions;
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monitor over time the relative calibration of standardized and modelled approaches, facilitating adjustments as needed; and
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provide macroprudential insight in an ex ante consistent format.
[Basel Framework, MAR11.8]
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All institutions must calculate the market risk capital requirement using the standardized approach for the following:
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securitization exposures; and
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equity investments in funds that cannot be looked through but are assigned to the trading book in accordance to the conditions set out in paragraph 65(5)(b).
[Basel Framework, MAR11.9]
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With respect to securitization exposures, asset backed securities that do not involve “at least two different stratified risk positions or tranches reflecting different degrees of credit risk” but might involve other sorts of tranching associated with pre-payment, as an example, are not considered products under this framework. As a consequence, such products can be treated as non-securitized positions for the purposes of credit spread risk capital requirements based on either the standardized framework or internal models. If in the standardized framework, these positions could also be subject to the residual risk add on if they are exposed to prepayment risk.
This section defines a trading desk, which is the level at which model approval is granted.
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For the purposes of market risk capital calculations, a trading desk is a group of traders or trading accounts that implements a well-defined business strategy operating within a clear risk management structure. [Basel Framework, MAR12.1]
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Trading desks are defined by the institution but subject to the regulatory approval of OSFI for capital purposes.
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An institution should be allowed to propose the trading desk structure per their organizational structure, consistent with the requirements set out in paragraph 55.
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An institution must prepare a policy document for each trading desk it defines, documenting how the institution satisfies the key elements in paragraph 55.
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OSFI will treat the definition of the trading desk as part of the initial model approval for the trading desk, as well as ongoing approval.
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OSFI may determine, based on the size of the institution’s overall trading operations, whether the proposed trading desk definitions are sufficiently granular.
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OSFI will check that the institution’s proposed definition of trading desk meets the criteria listed in key elements set out in paragraph 55.
[Basel Framework, MAR12.2]
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Within this OSFI-approved trading desk structure, institutions may further define operational subdesks without the need for OSFI approval. These subdesks would be for internal operational purposes only and would not be used in the market risk capital framework. [Basel Framework, MAR12.3]
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The key attributes of a trading desk are as follows:
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A trading desk for the purposes of the regulatory capital charge is an unambiguously defined group of traders or trading accounts.
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A trading account is an indisputable and unambiguous unit of observation in accounting for trading activity.
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The trading desk must have one head trader and can have up to two head traders provided their roles, responsibilities and authorities are either clearly separated or one has ultimate oversight over the other.
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The head trader must have direct oversight of the group of traders or trading accounts.
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Each trader or each trading account in the trading desk must have a clearly defined specialty (or specialties).
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Each trading account must only be assigned to a single trading desk. The desk must have a clearly defined risk scope consistent with its pre-established objectives. The scope should include specification of the desk’s overall risk class and permitted risk factors.
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There is a presumption that traders (as well as head traders) are allocated to one trading desk. An institution can deviate from this presumption and may assign an individual trader to work across several trading desks provided it can be justified to OSFI on the basis of sound management, business and/or resource allocation reasons. Such assignments must not be made for the only purpose of avoiding other trading desk requirements (e.g. to optimize the likelihood of success in the backtesting and profit and loss attribution tests).
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The trading desk must have a clear reporting line to institution senior management, and should have a clear and formal compensation policy clearly linked to the pre-established objectives of the trading desk.
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A trading desk must have a well-defined and documented business strategy, including an annual budget and regular management information reports (including revenue, costs and risk-weighted assets).
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There must be a clear description of the economics of the business strategy for the trading desk, its primary activities and trading/hedging strategies.
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Economics: what is the economics behind the strategy (e.g. trading on the shape of the yield curve)? How much of the activities are customer driven? Does it entail trade origination and structuring, or execution services, or both?
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Primary activities: what is the list of permissible instruments and, out of this list, which are the instruments most frequently traded?
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Trading/hedging strategies: how would these instruments be hedged, what are the expected slippages and mismatches of hedges, and what is the expected holding period for positions?
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The management team at the trading desk (starting from the head trader) must have a clear annual plan for the budgeting and staffing of the trading desk.
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A trading desk’s documented business strategy must include regular Management Information reports, covering revenue, costs and risk-weighted assets for the trading desk.
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A trading desk must have a clear risk management structure.
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Risk management responsibilities: the institution must identify key groups and personnel responsible for overseeing the risk-taking activities at the trading desk.
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A trading desk must clearly define trading limits based on the business strategy of the trading desk and these limits must be reviewed at least annually by senior management at the institution. In setting limits, the trading desk must have:
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well-defined trading limits or directional exposures at the trading desk level that are based on the appropriate market risk metric (e.g. sensitivity of credit spread risk and/or jump-to-default for a credit trading desk), or just overall notional limits; and
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well-defined trader mandates.
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A trading desk under the internal model approach must produce, at least weekly, appropriate risk management reports. This would include, at a minimum:
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profit and loss reports, which would be periodically reviewed, validated and modified (if necessary) by Product Control; and
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internal and regulatory risk measure reports, including trading desk VaR / ES, trading desk VaR/ES sensitivities to risk factors, backtesting and p-value.
[Basel Framework, MAR12.4]
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The institution must prepare, evaluate, and have available for OSFI the following for all trading desks:
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inventory ageing reports;
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daily limit reports including exposures, limit breaches, and follow-up action;
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reports on intraday limits and respective utilization and breaches for institutions with active intraday trading; and
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reports on the assessment of market liquidity.
[Basel Framework, MAR12.5]
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Any foreign exchange or commodity positions held in the banking book must be included in the market risk capital requirement as set out in paragraph 40. For regulatory capital calculation purposes, these positions will be treated as if they were held on notional trading desks within the trading book.
In the context of banking book FX and commodities positions, a “notional trading desk” does not necessarily have traders or trading accounts assigned to it, nor does it need to meet the qualitative trading desk requirements set out in this section. Institutions that wish to use the IMA to measure the FX or commodity risk of such notional trading desks must take at least one of the following actions:
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Transfer all or part of banking book FX and commodity risks to another trading desk via intra-trading book internal risk transfers (IRTs) (where trading desk requirements would continue to apply as appropriate for that desk);
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Apply for IMA approval for the notional trading desk. In this case, the notional desk only needs to meet the quantitative trading desk requirements.
Subject to certain conditions, certain traders can have ownership and responsibilities in both trading book and banking book portfolios.
[Basel Framework, MAR12.6]
This section sets out the instruments to be included in the trading book (which are subject to market risk capital requirements) and those to be included in the banking book (which are subject to credit risk capital requirements).
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A trading book consists of all instruments that meet the specifications for trading book instruments set out in paragraphs 59 through 70. All other instruments must be included in the banking book. [Basel Framework, RBC25.1]
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Instruments comprise financial instruments, foreign exchange (FX), and commodities. 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 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 a commodity, or an equity instrument. A financial liability is the contractual obligation to deliver cash or another financial asset or a commodity. Commodities also include non-tangible (i.e. non-physical) goods such as electric power.
The CSR capital requirement applies to money market instruments to the extent such instruments are covered instruments (i.e. they meet the definition of instruments to be included in the trading book as specified in paragraphs 59 through 70. [Basel Framework, RBC25.2]
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Institutions may only include a financial instrument, instruments on FX or commodity in the trading book when there is no legal impediment against selling or fully hedging it. [Basel Framework, RBC25.3]
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Institutions must fair value daily any trading book instrument and recognize any valuation change in the profit and loss (P&L) account.
Instruments designated under the fair value option may be allocated to the trading book, but only if they comply with all the relevant requirements for trading book instruments set out in section 9.2. [Basel Framework, RBC25.4]
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Any instrument an institution holds for one or more of the following purposes must, when it is first recognised on its books, be designated as a trading book instrument, unless specifically otherwise provided for in paragraph 60 or paragraph 64:
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short-term resale;
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profiting from short-term price movements;
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locking in arbitrage profits; or
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hedging risks that arise from instruments meeting (1), (2) or (3) above.
Evidence of periodic sale activity is insufficient on its own to consider such position as being held for short-term resale and, as such, is insufficient to meet sub-bullet (1).
[Basel Framework, RBC25.5]
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Any of the following instruments is seen as being held for at least one of the purposes listed in paragraph 62 and must therefore be included in the trading book, unless specifically otherwise provided for in paragraph 60 or paragraph 65:
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instruments in the correlation trading portfolio;
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instruments that would give rise to a net short credit or equity position in the banking book; or
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instruments resulting from underwriting commitments, where underwriting commitments refer only to securities underwriting, and relate only to securities that are expected to be actually purchased by the institution on the settlement date.
Institutions should have processes in place to manage and monitor their banking book positions to ensure that any instrument that individually has the potential to create a net short credit or equity position in the banking book is not actually creating a non-negligible net short position at any point in time. Such processes should include clear limit structures and an appropriate monitoring frequency. Institutions should be proactive in identifying potential non-negligible net short positions and limiting their occurrence.
As a general principle, instruments that give rise to a net short credit or equity position in the banking book must be assigned to the trading book unless a trading book treatment is explicitly excluded for the specific type of position. For example, if a credit default swap (CDS) that hedges loans in the banking book gives rise to a net short credit position, the net short position resulting from such instruments (i.e. the amount which cannot be offset against any long positions) must be treated as a trading book position and be subject to market risk capital requirements. [Basel Framework, RBC25.6]
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Any instrument which is not held for any of the purposes listed in paragraph 62 at inception, nor seen as being held for these purposes according to paragraph 63, must be assigned to the banking book. [Basel Framework, RBC25.7]
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The following instruments must be assigned to the banking book:
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unlisted equities;
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instruments designated for securitization warehousing;
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real estate holdings, where in the context of assigning instrument to the trading book, real estate holdings relate only to direct holdings of real estate as well as derivatives on direct holdings;
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retail and small or medium-sized enterprise (SME) credit, including commitments;
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equity investments in a fund, unless the institution meets at least one of the following conditions:
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the institution is able to look through the fund to its individual components at least on a quarterly basis, and there is sufficient and frequent information, verified by an independent third party, provided to the institution regarding the fund’s composition; or
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the institution obtains daily price quotes for the fund and it has access to the information contained in the fund’s mandate or in the national regulations governing such investment funds;
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hedge funds;
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derivative instruments and funds that have the above instrument types as underlying assets; and
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instruments held for the purpose of hedging a particular risk of a position in the types of instrument above.
[Basel Framework, RBC25.8]
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There is a general presumption that any of the following instruments are being held for at least one of the purposes listed in paragraph 62 and therefore are trading book instruments, unless specifically otherwise provided for in paragraph 60 or paragraph 65:
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instruments held as accounting trading assets or liabilities;
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instruments resulting from market-making activities;
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equity investments in a fund excluding those assigned to the banking book in accordance with paragraph 65(5);
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listed equities;
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trading-related repo-style transactions, which comprise those entered into for the purposes of market-making, locking in arbitrage profits or creating short credit or equity positions. Repo-style transactions that are (i) entered for liquidity management or (ii) valued at accrual for accounting purpose are not part of the presumptive list of paragraph 66. Institutions must have documentation for the definition of liquidity management and internal control processes to monitor these transactions, which should be made available to OSFI upon request; or
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options including embedded derivatives from instruments that the institution issued out of its own banking book and that relate to credit or equity risk.
Liabilities issued out of the institution’s own banking book that contain embedded derivatives and thereby meet the criteria of paragraph 66(6) should be bifurcated. This means that institutions should split the liability into two components: (i) the embedded derivative, which is assigned to the trading book; and (ii) the residual liability, which is retained in the banking book. No internal risk transfers are necessary for this bifurcation. Likewise, where such a liability is unwound, or where an embedded option is exercised, both the trading and banking book components are conceptually unwound simultaneously and instantly retired; no transfers between trading and banking book are necessary.
An option that manages FX risk in the banking book is covered by the presumptive list of trading book instruments included in paragraph 66(6). Only with explicit OSFI approval may an institution include in its banking book an option that manages banking book FX risk.
A floor to an equity-linked bond is an embedded option with an equity as part of the underlying, and therefore the embedded option should be bifurcated and included in the trading book.
[Basel Framework, RBC25.9]
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Institutions are allowed to deviate from the presumptive list specified in paragraph 66 according to the process set out below.
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If an institution believes that it needs to deviate from the presumptive list established in paragraph 66 for an instrument, it must submit a request to OSFI and receive explicit approval. In its request, the institution must provide evidence that the instrument is not held for any of the purposes in paragraph 62.
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In cases where this approval is not given by OSFI, the instrument must be designated as a trading book instrument. Institutions must document any deviations from the presumptive list in detail on an on-going basis.
Repo-style transactions not held for any of the purposes in paragraph 62 can be exempted from the list of presumptive trading book instruments in paragraph 66(5) and can be designated in the banking book for regulatory capital purposes.
[Basel Framework, RBC25.10]
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Apart from moves required by paragraphs 62 to 67, there is a strict limit on the ability of institutions to move instruments between the trading book and the banking book by their own discretion after initial designation, which is subject to the process in paragraphs 72 and 73. Switching instruments for regulatory arbitrage is strictly prohibited. In practice, switching should be rare and will be allowed by OSFI only in extraordinary circumstances. Examples are a major publicly announced event, such as an institution restructuring that results in the permanent closure of trading desks, requiring termination of the business activity applicable to the instrument or portfolio or a change in accounting standards that allows an item to be fair-valued through P&L. Market events, changes in the liquidity of a financial instrument, or a change of trading intent alone are not valid reasons for reassigning an instrument to a different book. When switching positions, institutions must ensure that the standards described in paragraphs 62 to 67 are always strictly observed. [Basel Framework, RBC25.14]
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Without exception, a capital benefit as a result of switching will not be allowed in any case or circumstance. This means that the institution must determine its total capital requirement (across the banking book and trading book) before and immediately after the switch. If this capital requirement is reduced as a result of this switch, the difference as measured at the time of the switch will be imposed on the institution as a disclosed Pillar 1 capital surcharge. This surcharge will be allowed to run off as the positions mature or expire, in a manner agreed with OSFI. To maintain operational simplicity, it is not envisaged that this additional capital requirement would be recalculated on an ongoing basis, although the positions would continue to also be subject to the ongoing capital requirements of the book into which they have been switched. The disallowance of capital benefits as a result of switching positions from one book to another applies without exception and in any case or circumstance. It is therefore independent of whether the switch has been made at the discretion of the institution or is beyond its control, e.g. in the case of the delisting of an equity. [Basel Framework, RBC25.15]
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Any reassignment between books must be approved by senior management and OSFI as follows. Any reallocation of securities between the trading book and banking book, including outright sales at arm’s length, should be considered a reassignment of securities and is governed by requirements of this paragraph.
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Any reassignment must be approved by senior management; thoroughly documented; determined by internal review to be in compliance with the institution’s policies; subject to prior approval by OSFI based on supporting documentation provided by the institution; and publicly disclosed.
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Unless required by changes in the characteristics of a position, any such reassignment is irrevocable.
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If an instrument is reclassified to be an accounting trading asset or liability there is a presumption that this instrument is in the trading book, as described in paragraph 66. Accordingly, in this case an automatic switch without approval of OSFI is acceptable.
The treatment specified for internal risk transfers applies only to risk transfers done via internal derivatives trades. The reallocation of securities between trading and banking book should be considered a re-assignment of securities and is governed by this paragraph.
Moving instruments between the trading book and the banking book should be rare. The movement of an instrument from the trading book to the banking book requires OSFI approval. Where an instrument is reclassified as an accounting trading asset or liability and per sub-bullet (3) above, and is switched to a trading book instrument for capital requirement purposes without OSFI approval, the disallowance of capital requirement benefits specified in paragraph 72 will apply.
[Basel Framework, RBC25.16]
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An institution must adopt relevant policies that must be updated at least yearly. Updates should be based on an analysis of all extraordinary events identified during the previous year. Updated policies with changes highlighted must be sent to OSFI. Policies must include the following:
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The reassignment restriction requirements in paragraphs 71 through 73, especially the restriction that re-designation between the trading book and banking book may only be allowed in extraordinary circumstances, and a description of the circumstances or criteria where such a switch may be considered.
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The process for obtaining senior management and OSFI approval for such a transfer.
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How an institution identifies an extraordinary event.
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A requirement that re-assignments into or out of the trading book be publicly disclosed at the earliest reporting date.
Institutions are permitted to exclude the following from the restrictions on moving instruments between regulatory books noted in paragraphs 71 to 73:
- CAD-denominated Level 1 and Level 2A High Quality Liquid Assets (HQLA); and
- non CAD-currency denominated Level 1 and Level 2A HQLA issued by Canadian entities,
as defined in Chapter 2 of OSFI’s Liquidity Adequacy Requirements Guideline.
Where an institution’s Treasury purchases new issuances of the institution’s own stamped Bankers Acceptances from its dealer, such securities do not need to be included within the restrictions on moving instruments noted in paragraphs 71 to 73.
[Basel Framework, RBC25.17]
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When an institution hedges a banking book interest rate risk exposure using an internal risk transfer with its trading book on or after the beginning of the institution’s fiscal Q1-2024, the trading book leg of the internal risk transfer is treated as a trading book instrument under the market risk framework if and only if:
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the internal risk transfer is documented with respect to the banking book interest rate risk being hedged and the sources of such risk;
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the internal risk transfer is conducted with a dedicated internal risk transfer trading desk which has been specifically approved by OSFI for this purpose; and
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the internal risk transfer must be subject to trading book capital requirements under the market risk framework on a stand-alone basis for the dedicated internal risk transfer desk, separate from any other GIRR or other market risks generated by activities in the trading book.
Similar to the notional trading desk treatment set out in paragraph 57 for foreign exchange or commodities positions held in the banking book, general interest rate (GIRR) internal risk transfers (IRT) may be allocated to a trading desk that may not have traders or trading account assigned to it. For a GIRR IRT trading desk, only the quantitative requirements (i.e. PLA test and backtesting) set out in section 9.6.3 apply, while the qualitative criteria for trading desks as set out in paragraph 55 do not apply. A GIRR IRT desk must not have any trading book positions allocated to it, except GIRR IRTs between the trading book and the banking book as well as any external hedges that meet the conditions specified in paragraph 84.
[Basel Framework, RBC25.25]
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Where the requirements in the paragraph above are fulfilled, the banking book leg of the internal risk transfer must be included in the banking book’s measure of interest rate risk exposures for regulatory capital purposes. [Basel Framework, RBC25.26]
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The OSFI-approved internal risk transfer desk may include instruments purchased from the market (i.e. external parties to the institution). Such transactions may be executed directly between the internal risk transfer desk and the market. Alternatively, the internal risk transfer desk may obtain the external hedge from the market via a separate non-internal risk transfer trading desk acting as an agent, if and only if the GIRR internal risk transfer entered into with the non-internal risk transfer trading desk exactly matches the external hedge from the market. In this latter case the respective legs of the GIRR internal risk transfer are included in the internal risk transfer desk and the non-internal risk transfer desk.
External hedges for the purposes of this paragraph can be made up of multiple transactions with multiple counterparties as long as the aggregate external hedge exactly matches the internal risk transfer, and the internal risk transfer exactly matches the aggregate external hedge.
The term ‘exactly matches’ implies that the external hedge is considered to be effective if changes in fair value of the external hedge and the internal hedge are within a range of 90% to 110%. This assessment of effectiveness is to be done at inception and on a monthly basis thereafter, and the external hedge must be identified within five business days of the internal hedge. Institutions are expected to capture any residual risks add-on between the internal and external hedge with respect to instruments with exotic underlying and instruments bearing other residual risks, consistent with section 9.5.4.
[Basel Framework, RBC25.27]
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Eligible external hedges that are included in the credit valuation adjustment (CVA) capital requirement, and FX and commodity risk arising from CVA hedges that are eligible under the CVA standard, must be removed from the institution’s market risk capital requirement calculation. [Basel Framework, RBC25.30]
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Institutions may enter into internal risk transfers between the CVA portfolio and the trading book. Such an internal risk transfer consists of a CVA portfolio side and a non-CVA portfolio side. Where the CVA portfolio side of an internal risk transfer is recognised in the CVA risk capital requirement, the CVA portfolio side should be excluded from the market risk capital requirement, while the non-CVA portfolio side should be included in the market risk capital requirement. [Basel Framework, RBC25.31]
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In any case, such internal CVA risk transfers can only receive regulatory capital recognition if the internal risk transfer is documented with respect to the CVA risk being hedged and the sources of such risk. [Basel Framework, RBC25.32]
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Internal CVA risk transfers that are subject to curvature, default risk or residual risk add-on as set out in section 9.5 may be recognised in the CVA portfolio capital requirement and market risk capital requirement only if the trading book additionally enters into an external hedge with an eligible third-party protection provider that exactly matches the internal risk transfer. [Basel Framework, RBC25.33]
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Independent from the treatment in the CVA risk capital requirement and the market risk capital requirement, internal risk transfers between the CVA portfolio and the trading book can be used to hedge the counterparty credit risk exposure of a derivative instrument in the trading or banking book as long as the requirements of paragraph 78 are met. [Basel Framework, RBC25.34]
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The revised CVA framework (see Chapter 8) now captures both the risk and hedges of CVA (including both the credit risk and exposure components). As such, any other transactions related to the management of CVA risk will not be covered in the market risk framework. In addition, institutions are not permitted to include sensitivities to other valuation adjustment (commonly referred to as xVA) in the market risk framework. However, any market risk hedges of xVA risk must be included in the market risk framework with the following exceptions:
- Any market risk hedges of collateral valuation adjustments (ColVA sometimes referred to as overnight indexed swap or OIS discounting) that meet the conditions for eligibility listed in the paragraph below; and,
- Any market risk hedges of the exposure component of funding VA (FVA).
Hedges of ColVA and hedges of the exposure component of FVA can be excluded from the market risk framework if all of the following conditions are met:
- Institutions have a well-defined and nominated trading desk that satisfies the organizational structure described in paragraph 55. That structure must include an independent risk control unit responsible for the design, documentation, and implementation of the measurement of FVA and ColVA risk. This unit should report directly to senior management of the institution.
- The excluded hedges are evidenced to be risk reducing at their inception according to the documented measure of FVA and/or ColVA risk through the use of: (i) risk factor identification processes, (ii) regular assessment of risk capture between unhedged- and hedged-P&L, (iii) P&L attribution assessment and stress testing programs as described in paragraph 272 and; (iv) an independent model validation process as per paragraph 273.
- The excluded hedges are initiated, tracked and managed as a hedge of either ColVA or the exposure component of FVA in accordance with internal protocols for compliance that are consistent with paragraph 278 and internal audit/validation functions in paragraph 281.
Institutions must measure and monitor the effectiveness of the excluded hedges in normal conditions and in times of stress. Institutions should assess any material residual or basis risk as part of their stress testing programs (e.g., ICAAP, etc.) and account for this in Pillar 2 capital in excess of minimum requirements commensurate with their risk profile.
OSFI will consider other regulatory frameworks as being adequate substitutes for meeting these requirements in order to mitigate duplication for institutions seeking these exemptions.
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Institutions must establish and maintain procedures for judging the necessity of and calculating an adjustment to the current valuation of less liquid positions for regulatory capital purposes. This adjustment may be in addition to any changes to the value of the position required for financial reporting purposes and should be designed to reflect the illiquidity of the position. OSFI expects institutions to consider the need for an adjustment to a position’s valuation to reflect current illiquidity whether the position is marked to market using market prices or observable inputs, third-party valuations or marked to model. [Basel Framework, CAP50.11]
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Bearing in mind that the assumptions made about liquidity in the market risk capital requirement may not be consistent with the institution’s ability to sell or hedge out less liquid positions, where appropriate, institutions must take an adjustment to the current valuation of these positions, and review their continued appropriateness on an on-going basis. Reduced liquidity may have arisen from market events. Additionally, close-out prices for concentrated positions and/or stale positions should be considered in establishing the adjustment. Institutions must consider all relevant factors when determining the appropriateness of the adjustment 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 (including trading volumes during periods of market stress), market concentrations, the aging of positions, the extent to which valuation relies on marking-to-model, and the impact of other model risks not included in the paragraph above. [Basel Framework, CAP50.12]
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For complex products including, but not limited to, securitization exposures and n-th-to-default credit derivatives, institutions must explicitly assess the need for valuation adjustments to reflect two forms of model risk: the model risk associated with using a possibly incorrect valuation methodology; and the risk associated with using unobservable (and possibly incorrect) calibration parameters in the valuation model. [Basel Framework, CAP50.13]
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The adjustment to the current valuation of less liquid positions made under paragraph 105 must impact Common Equity Tier 1 regulatory capital and may exceed those valuation adjustments made under financial reporting standards and paragraphs 102 and 103. [Basel Framework, CAP50.14]
This section sets out the general provisions and the structure of the standardized approach for calculating risk-weighted assets for market risk.
This section sets out the calculation of the sensitivities-based method under the standardized approach for market risk.