With the Basel committee’s updated FRTB rules on market risk finalised earlier this year, attention has turned to local prudential regulators and how they plan to interpret these requirements in their respective jurisdictions. The next phase of rolling out the long-awaited rules will be a critical juncture that determines whether they successfully aid the industry in understanding and managing market risk or whether they become an overly complex web of requirements that are just too challenging to implement.
The EU was the first jurisdiction to commence the process of transposing FRTB into local law by publishing CRR2 in the EU’s Official Journal in June this year. However, possibly of more interest are the steps taken later the same month, when the EBA published a series of consultations papers covering topics such as liquidity horizons, PLAT and back testing as well as modellability. Hot on the heels of the EU, the following day HKMA released their consultation paper describing their proposals on how the full suite of FRTB requirements would be adopted in Hong Kong. Other jurisdictions are expected to follow the EU and HK by releasing their own consultation papers later this year and into next year.
In today’s blog we look at some of the questions that were raised in the EU’s consultation paper on risk factor modellability and discuss whether they’re likely to help or hinder the underlying policy objectives associated with this controversial new liquidity test within the FRTB regulation.
Should committed quotes be required to have both a firm bid and offer price?
The EBA proposed that quotes should have both a firm bid and offer price to be eligible for inclusion in the risk factor eligibility test. Such a requirement would mean those markets operating under firm single sided quotes would no longer be able to use committed quotes and would become fully reliant on executed trade data.
To better understand the materiality of this requirement let’s take a sample of data. Committed quote data in bond and derivative markets is generally not widely available so let’s take one of the most well know and extensive sources – MiFID II. Our analysis covers a sample of 240K+ quotes from a single week published by a variety of major reporting platforms and trading venues. As you can see from the charts below, all these quotes are either bids, offers or unclassified. Not a single one had both a firm bid and an offer. Whilst there are clearly many markets that operate on two sided quotes this demonstrates that there is also extensive prevalence of markets that operate using single sided quotes.
Given the significant availability of single sided quotes in bond and derivative markets, Refinitiv are concerned that mandating committed quotes eligible for RFET must have both a firm bid and offer price would limit the availability of data to the point where it is no longer a fair reflection of activity taking place in the market.
How do you define “non-negligible volume”?
The EBA’s modellability consultation paper also poses the question how to define the concept of “non-negligible volume of a transaction or quote, as compared to usual transaction sizes for the bank, reflective of normal market conditions” as introduced in the BCBS’s FAQs. Whilst Refinitiv are highly supportive of the concept; implementing a strict definition raises a material practical challenge. Given each market has very different characteristics, such thresholds would need to apply at a granular level, however, many of these markets are opaque so lack transparency from which these thresholds could be accurately calibrated.
How do you define an “unreasonably large bid-offer spread”?
The EBA introduce the concept of “unreasonably large bid-offer spread as compared to usual bid-offer spreads, reflective of normal market conditions”. Whilst Refinitiv are supportive of such a concept the actual implementation become unduly challenging for several reasons. The first being that as illustrated earlier, many markets operate with either firms bids or offers, so don’t have a firm bid offer spread. Secondly for those markets that operate using two sided quotes, it can be very challenging to define what is unreasonable as this will vary significantly by instrument and over time.
In conclusion, as we move from global standards and towards local requirements in each jurisdiction, it is important that any further definitions introduced are consistent with market convention. This should ensure alignment with the policy objective. In addition, it is critical that global consistency is maintained as variation across jurisdictions will lead to higher operational complexity and a disproportionate cost impact. Find out further information on Refinitiv’s response to the EBA modellability consultation paper and HKMA’s market risk consultation paper
FRTB early access program
Register for our FRTB early access program. Our new Refinitiv Trade Discovery solution supports our customers with the Risk Factor Eligibility Test (RFET), and we are currently conducting an early access program. Participation will provide you with evidence of “real” observations across a range of asset classes from which you can commence your RFET testing.