Are popular trading strategies under pressure with FRTB?

The Fundamental Review of Trading Book (FRTB) will absolutely change the trading game, due to be implemented in 2019. FRTB will require a major overhaul of current risk management practices and will have a profound effect on cost structure and strategy.

What are the main changes in FRTB?

  • A revised boundary between trading and banking book which limits the ability to move products across books, restricting a common method of capital savings (arbitrage) used by banks to date.
  • The replacement of “Value at Risk” (VaR) for the more conservative “Expected Shortfall”(ES) as the market risk metric under stress.
  • A new rigorous desk level approval regime for banks that seek to use their own internal models to measure market risk.
  • revised standardized approach for market risk measurement which can also serve as a fall back and capital floor for internal models.
  • The introduction of liquidity horizons for risk factors, in an attempt to improve the current framework which inadequately assumes that trading book positions can be hedged or exited over a 10-day period.

Overall FRTB will result in significantly higher capital requirements and may continue to shrink profit margins, particularly for financial institutions with substantial market risk exposure and activity in complex financial products. As such, it is imperative that banks are able to implement risk models that are both compliant and cost efficient.

“Many banks may have to completely rethink how they hedge their exposure, and could heavily impact certain desks business models.”

Has FRTB a greater impact on how your entire trading business is run?

FRTB will impact your trading business greater than just serving as a vehicle for a capital charge calculation. It has a level of structure and a greater prescribed approach how to model your business. Trading desks are likely to move between the sensitivity based approach and the internal models approach, and so the front office will want input into market risk setup – regulatory compliance must be achieved in a way that benefits the business.

The boundary between the Trading book and Banking book needs to be tightly defined.

FRTB requires that business be allocated to either the trading or banking book, and not jump the boundary in an arbitrary way. This means revisiting any previous approach to modelling this structure, embedding it in an electronic representation, and ongoing monitoring.

The way market risk is measured is changing.

The new requirements will impose significant changes to measuring Market Risk (which will become inputs to the Capital Charge). Moving from VaR to Expected Shortfall will increase the amount of computational effort.

All models need regulatory approval.

For business which requires an internal model, you must obtain, receive and maintain regulatory approval for the model. Any internal calculation model will need an approval from your regulator at a desk level. Approval maintenance will be based on three criteria – P&L attribution, back testing and a model independent assessment. Determining which desks rely on an internal model and which on the standard approach has timing constraints which prevent switching desks rapidly from one to the other.

The success of the output of your FRTB platform needs desk level monitoring.

Each desk will need to be monitored to observe price inputs for the last quoted price, last traded date, and adequacy of inputs, and should be alerted in real-time to avoid punitive capital charges.

The availability of data has a direct impact on your FRTB output.

The underlying market data must be updated daily to avoid the above exceptions – any portfolio which fails under an internal model due to poor data will fall back to the standard approach and a potentially higher capital charge.

Expanded Computing Power Requirements.

The amount of computation needed to create the output is dramatically greater than for market risk including Expected Shortfall as the main exposure measure whilst maintaining VaR for back-testing, stress testing and default risk (under IMA). These risk treatments will mean there will be significant increases in computational processing power, aggregation and reporting which current systems will not easily be able to accommodate

Which trading strategies are in danger under FRTB?

In first place, popular hedge fund strategies – such as volatility trading – may turn out to be really unprofitable. The capital charge for warehousing exotic market risk will drastically increase with FRTB. Therefore, the whole buy side operations will be changed. Investment managers will say “ok, we have to look at the “wing risk” and have to exit those strategies and won’t be trading those products”.

Volatility strategies are particularly vulnerable. The whole buy side operations and business with a very volume-driven trades will be changed.

Volatility strategies are particularly vulnerable. Hedge fund managers will need to be more innovative if a trader is charged more for short volatility and he is buying, then the fund is paying more which is basically inefficient. All exotic product lines will be affected such as open variance swap position. The trading with a very volume-driven business will certainly be under pressure.

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