Earlier this year, regulators updated select elements of the Fundamental Review of the Trading Book regulation, namely the Risk Factor Eligibility Test. Find out how Refinitiv raised awareness of select issues and is supporting the industry through these changes.
- Some elements of the Risk Factor Eligibility Test were so challenging that we questioned whether it was fully consistent with the regulation’s policy objective.
- Refinitiv raised concerns about three areas of the regulation in particular — bucketing, the requirement for one observation per month and deferred publication under MiFID II.
- Passing the Risk Factor Eligibility Test is now more achievable after regulators made a number of changes.
In January 2016, we were asked by our customers to support them with the newly introduced Fundamental Review of the Trading Book (FRTB) regulation, and in particular the Risk Factor Eligibility Test (RFET).
Refinitiv completed much work with our customers to support them in getting a better understanding of how the test behaves in the real world. This analysis threw up some fascinating results and highlighted a series of unexpected challenges.
Select elements of RFET were so challenging that we questioned whether it was fully consistent with the policy objective that it was designed to address.
In March 2018, the Basel Committee on Banking Supervision released a consultative paper on FRTB, which provided us with an opportunity to share our insights on RFET with prudential regulators.
We hoped that any misalignment between the results from the RFET analysis and the policy objectives could be resolved prior to the rules coming into force.
Our concerns included:
- Bucketing defined in the March 2018 consultation made it challenging for some liquid securities to pass the eligibility test.
- Requiring each risk factor to have at least one observation per month limits all but the most liquid instruments from passing the Risk Factor Eligibility Test.
- The deferred publication requirements under some transparency regimes such as MiFID II risked existing data being ineligible for part of the assessment.
Watch: Refinitiv helped make passing the FRTB RFET more achievable
Refinitiv implemented the proposed RFET framework over the U.S. corporate bond market and noticed that some segments of the market struggled to pass the test.
The first two maturity buckets — up to six months and 6-12 months had a 0% pass rate.
The fixed nature of a bond’s maturity means the remaining maturity decreases and the observations for a given bond get allocated to different risk factors over time.
As the two shortest maturity buckets are less than one year, a single bond is only allocated to a given risk factor for six months. This makes it very challenging to have observations every month for a 12 month period.
Refinitiv shared these insights with the industry and regulators during 2018. We were pleased to see the updated rules published in January 2019 address this concern.
Not only does the regulatory bucketing approach now typically have fewer maturity buckets, there are also new rules that provide increased flexibility about how bonds can be mapped to maturity buckets.
One observation per month
The requirement for one observation per month concerned us because we know many of the less liquid markets can often be characterized by episodical trading behavior that make it very challenging for many risk factors to pass this requirement.
Analysis of the U.S. corporate bond market provided a number of interesting insights.
As of the 2018 RFET rules, only 43 percent of risk factors based on U.S. corporate bond data would pass the test.
This is an important finding in our eyes since the U.S. corporate bond market is one of the most liquid and actively traded corporate bond markets, and thanks to FINRA TRACE it’s also one of the most transparent.
Secondly, we also identified a misalignment between the requirement for one observation per month and 24 observations per year. The former is consistently more conservative than the latter.
Refinitiv shared these insights with the industry and regulators during 2018, and we were pleased that the updated rules dealt with these concerns.
The one month test was replaced by four observations in any 90-day period, and a new test was added for risk factors with 100+ observations per year to pass RFET.
These changes aid passing the Risk Factor Eligibility Test by allowing liquid but episodic bond trading, plus the requirement of 100+ observations per year aids newly issued bonds to pass.
MiFID II and the Risk Factor Eligibility Test
One of the most material challenges relating to the RFET is the sourcing of trades and committed quotes in OTC markets.
These markets are frequently not transparent, meaning that trade data typically isn’t published to the market. In order to create a level playing field, Refinitiv believes it’s important that banks have access to a wide variety of data.
Where possible, existing forms of transparency should be used because this provides the most cost-effective means by which to source observation data.
MiFID II is a new capital markets regulation. From January 2018, it requires trading venues and market participants within the EU to publish pre- and post-trade transparency on equities, bonds and derivatives.
The regime permits trades in less liquid instruments and large sizes to be deferred by more than four weeks. Our analysis on a data sample shows that 86 percent of the trades were subject to a maximum deferral of more than four weeks.
Since 2018, Refinitiv has been concerned about the interaction of the RFET requirement for one observation per month and the presence of the delays in MiFID II post-trade data. Refinitiv shared these insights with the industry and regulators.
The updated rules address these concerns through two key mechanisms:
- Moving away from the requirement of having at least one observation per month to four observations in 90 days mean that the deferred data makes passing the Risk Factor Eligibility Test more challenging, but no longer impossible.
- There are special allowances for data published under a deferred publication. For these data sources, banks are permitted an additional month to collect, consolidate and process the data for running RFET.
Real price observation data
Refinitiv is supporting customers with the RFET through the provision of “real” price observation data. The Refinitiv Trade Discovery product has been designed and built in conjunction with the industry.
RFET-compliant information is sourced using a combination of:
- Regulatory initiatives (such as MiFID II, FINRA TRACE, etc.)
- Contributions from market infrastructure providers to source observations for OTC markets