Allocation of Positions to the Trading Book

Circular Allocation of Positions to the Trading Book

CIRCULAR: 27/2011 DATE: 18.10.2011 THE CIRCULAR APPLIES TO: Securities Firms

FINANS TILSYNET Postboks 1187 Sentrum 0107 Oslo

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1 Introduction In connection with the supervision of the rules on large exposures, the Financial Supervisory Authority has learned that some securities firms have incorrectly allocated too many exposures to the "trading book." This has, among other things, affected the firms' compliance with the provision that a total exposure to a single counterparty must not exceed an amount equivalent to 25 percent of the firm's eligible capital. This therefore also affects the concentration risk in the firms.

This circular does not provide an exhaustive description of the capital adequacy rules, but describes what the Financial Supervisory Authority will base its supervisory work on when assessing which positions may be included in the firms' trading book.

Point 2 provides an overview of the current rules and relevant interpretative elements from EU regulations. Point 3 gives examples of which positions may be included in the trading book. Point 4 discusses requirements for guidelines related to the trading book. Points 5 and 6 provide a brief overview of valuation and the relationship to accounting rules.

2 The Rules It follows from the Regulation on Large Exposures of Credit Institutions and Securities Firms § 5, first paragraph, that the firm may not have a higher total exposure than is at any time considered prudent, and that the total exposure must not exceed an amount equivalent to 25 percent of the firm's eligible capital. It follows from the same Regulation § 10 that the firm may exceed the 25 percent limit if the exceedance is solely due to exposures linked to the trading book and if requirements for supplementary eligible capital are met.

Which positions shall be included in the trading book is regulated by the Capital Requirements Regulation § 31-1. Only when the positions meet the requirements in the Capital Requirements Regulation to be included in the trading book can these exposures be calculated in accordance with the rules in Chapter 2 of the Regulation on Large Exposures.

According to the Capital Requirements Regulation § 31-1 (1), the trading book consists of positions in financial instruments, as well as commodities and credit derivatives, which the firm holds on its own account with a view to resale, or to profit in the short term from price or interest rate variations, as well as hedging such positions. Positions referred to in Chapter 37 of the Capital Requirements Regulation (e.g., unsettled transactions and uncompleted transactions) that are linked to the instruments mentioned in the first sentence shall be included.

The central criterion for positions to be included in the trading book is that these positions are linked to financial instruments that the firm "holds on its own account with a view to resale or to profit in the short term from price or interest rate variations," cf. the Capital Requirements Regulation § 31-1 (1) first sentence. The provision in the Capital Requirements Regulation § 31-1 (1) first sentence shall be interpreted in accordance with Directive 2006/49/EC.

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In the Directive, the central criterion for categorization in the trading book is referred to as "trading intent." "Trading intent" is defined in Article 11 (2) as "Positions held with trading intent are those held intentionally for short-term resale and/or with the intention of benefiting from actual or expected short-term price differences between buying and selling prices or from other price or interest rate variations." It further states that "[t]he term 'positions' shall include proprietary positions and positions arising from client servicing and market making."

The Financial Supervisory Authority clarifies that where "positions" is mentioned in the second sentence, it refers back to "[...] positions held with trading intent [...]" as appears from the first sentence of the article.

The Directive text is largely based on the Basel Accords1. In Basel Accord point 687, "trading intent" is described as follows: "Positions held with trading intent are those held intentionally for short-term resale and/or with the intent of benefiting from actual or expected short-term price movements or to lock in arbitrage profits, and may include for example proprietary positions, positions arising from client servicing (e.g. matched principal broking) and market making." (Financial Supervisory Authority's emphasis.)

In the British Financial Services Authority (FSA) interpretative statement in the Prudential sourcebook for Banks, Building Societies and Investment Firms (BIPRU), the following appears in section 1.2.5: "Positions arising from client servicing include those arising out of contracts where a firm acts as principal (even in the context of activity described as 'broking' or 'customer business'). Such positions should be allocated to a firm's trading book if the intent is trading." (Financial Supervisory Authority's emphasis.)

Positions included in the trading book may originate from both active short-term proprietary trading, but also from "client servicing" and "market making." In any case, there is a requirement that the firm must have had a conscious "trading intent" with the positions allocated to the trading book (regardless of how they arose).

The Financial Supervisory Authority assumes that Directive Article 11 (3) and Part A "Trading Intent" in Annex VII, see further discussion in point 4 below, are not only an expression of the requirements placed on the firm's management and control of the trading book, but also indirectly provide guidance regarding which positions naturally belong in the trading book.

3 Which positions shall be included in the trading book? The Financial Supervisory Authority will below give some non-exhaustive examples of which positions, in the Financial Supervisory Authority's assessment, should be included in the trading book.

It is not the case that all positions where the firm is or was a party to the contractual relationship linked to a financial instrument shall be allocated to the firm's trading book.

1 International Convergence of Capital Measurement and Capital Standards: A Revised Framework (Comprehensive Version: June 2006) from Basel Committee on Banking Supervision

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Client broking, where the firm buys and sells securities for its own customers in its own (the firm's) name, will not, for example, be included in the trading book. Customer claims and unsettled claims linked to the broking will also not be included in the trading book.

The Financial Supervisory Authority wishes to emphasize that it is not to be understood that the firm can only broker/arrange items for a customer as long as these in sum do not exceed 25 percent of the firm's eligible capital. There is no such limitation in the current rules for capital adequacy or large exposures. Unsettled transactions linked to such purchases or sales of securities are only to be counted as an exposure if settlement has not taken place within five business days after the agreed settlement time, cf. the Regulation on Large Exposures § 4, third paragraph, letter a.

When entering into a futures contract, the firm will assume price risk and counterparty risk. Whether the firm is considered to have entered into the futures contract with "trading intent," and thus that the position should be included in the trading book, must depend on a concrete assessment. This assessment must be based on the firm's guidelines and procedures for the trading book. The firm's trading activity, any elimination of price risk by purchasing underlying instruments or use of an external writer, possibility for daily valuation of the position, liquidity in the underlying instruments and the futures contract's maturity will be relevant assessment topics.

4 Requirements for guidelines, procedures and monitoring of the trading book It follows from the Capital Requirements Regulation § 31-4 that the firm shall have guidelines and procedures for which positions may be included in the trading book, and for the management, valuation, and monitoring of the trading book.

The firm's guidelines and procedures should as a minimum meet the requirements in Annex VII part A and D in Directive 2006/49/EC.

The firm shall have a clear and documented trading strategy for the trading book. The strategy shall indicate the expected investment horizon, and specifically list which financial instruments or categories of financial instruments may be included in the firm's trading book, with frameworks for position taking. The strategy shall be adopted and regularly reviewed by the firm's board of directors.

The firm's frameworks for position taking must be delegated to the trading unit. The firm's traders shall only have authority to trade on their own initiative within the set frameworks and the firm's trading strategy.

The firm shall have guidelines and procedures for the valuation of the trading book. These shall contain a clear distribution of responsibility for the different work processes involved in the valuation. It shall be stated which sources for market data and information shall be used in the valuation, and how and how frequently the suitability of these sources shall be assessed. It must further state how frequently an independent valuation shall be performed, times for closing prices, guidelines and procedures for adjustment of valuation and verification at month-end and on an ad hoc basis.

The valuation of the firm's trading book shall be performed by a unit independent of the trading unit, and shall be reported regularly and as needed to the board of directors. Independent verification of the market prices that shall be included in the valuation shall take place at least monthly.

The firm shall have systems and control functions that ensure correct valuation of the trading book. The positions in the trading book shall be actively monitored. The firm's actual position taking, the frameworks for position taking, and market conditions relevant for closing positions shall be assessed continuously.

The firm shall have guidelines and procedures for any reclassification of positions between the trading book and the banking book.

Position taking and risk in the trading book, including the utilization of the adopted frameworks for position taking, shall be reported to the board of directors. Furthermore, the reporting to the board shall enable assessment of compliance with the firm's trading strategy, and provide an overview of turnover rates and illiquid positions in the trading book. The reporting to the board shall cover the firm's compliance with laws, regulations, and internal guidelines and procedures in the area.

The Financial Supervisory Authority assumes that in firms that have internal audit, it will be natural for the internal audit to periodically review the institution's guidelines, procedures, and practices for the trading book.

5 Valuation It follows from the Capital Requirements Regulation § 31-2, first paragraph, that the firm's trading book shall be valued at market value at least daily, and that foreign currency shall be converted at the spot rate. Furthermore, it follows from the Capital Requirements Regulation § 31-2, second paragraph, that if market value cannot be determined according to the first paragraph, the firm shall use a model value. The firm shall regularly assess whether the model's results and the assumptions underlying it are prudent.

Rolling over contracts in the trading book at old rates is not considered to be in line with the requirements in the Capital Requirements Regulation § 31-2.

The Financial Supervisory Authority reminds that firms shall have procedures for calculating value adjustments of less liquid positions for capital adequacy purposes. The procedures shall cover positions valued at fair value and shall cover both positions placed in the banking and trading books.

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6 Relationship to Accounting Rules Categorization of positions in the trading book when calculating the firm's capital requirements is not necessarily coincident with the accounting concept of trading book, cf. the Accounting Act § 5-8, first paragraph, or financial assets classified as held for trading under IAS 39 no. 9.

Positions that meet the requirements to be included in the trading book shall be treated in accordance with the provisions in the Capital Requirements Regulation Part VII, regardless of the accounting treatment of the positions.

Eirik Bunæs Geir Holen Contact Person: First Consultant Anders Hauglund, tel. 22 93 99 87, email: anders.hauglund@finanstilsynet.no

FINANS TILSYNET Postboks 1187 Sentrum 0107 Oslo POST@FINANSTILSYNET.NO WWW.FINANSTILSYNET.NO