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The VR Revisions and FRTB

Traders Magazine Online News, July 2, 2018

George Bollenbacher

In the never-ending world of regulatory reform, even the rollbacks of unpopular rules can have unintended consequences, particularly as they bump up against other rules in the process of being formulated. Such is the case between the proposed revisions to the Volcker Rule (VR) and the often-delayed Fundamental Review of the Trading Book (FRTB). The implications of these two developments are buried in the voluminous texts, but they are real nonetheless.

Some Basic Concepts

The two rules take a very different approach to the same perceived issue, the regulation and management of trading risk by banks. The VR, a US-based rule, prohibits trading by banks, except under certain specific and verifiable exemptions. The FRTB, a global rule, focuses on the capital requirements for carrying trading positions (the “trading book”), but not for carrying other positions (the “banking book”). As a result, the boundary line between trading books and other books becomes a big deal for both rules, and is our first point of reference.

The FRTB Approach

In the 2016 version, FRTB approaches this boundary on an instrument basis – saying, “A trading book consists of all instruments that meet the specifications” in the list it provides. It defines a financial instrument as “any contract that gives rise to both a financial asset of one entity and a financial liability or equity instrument of another entity.”

But then it complicates things by saying, “Any instrument a bank holds for one or more of the following purposes must be designated as a trading book instrument:

(a) short-term resale;

(b) profiting from short-term price movements;

(c) locking in arbitrage profits;

(d) hedging risks that arise from instruments meeting criteria (a), (b) or (c) above.“

In other words, any instrument not on the original list can be considered part of the trading book, based on the bank’s motivation in taking the position. So, after starting out admirably by providing a black-and-white definition, FRTB introduces a varying-shades-of-gray approach which has been shown in the past to lead to confusion.

Then the 2018 FRTB update says, “The Committee has identified that in some cases financial instruments can be both in the list of instruments that must be in a particular book, and in the list that are expected to be in the other book. In these cases, it may not be clear which requirement takes precedence.” As a clarification, it says, “banks may assign to the trading book funds: (i) for which daily price quotes are available; (ii) which track a non-leveraged benchmark; and (iii) which demonstrate a tracking difference, ignoring fees and commissions, for which the absolute value is less than 1%.” Given that a bank would always rather assign a position to the banking book, I’m not sure what the term “may” means or accomplishes.

The VR Approach

The original VR (Section 13 of the Bank Holding Company Act) expressly prohibits banks from engaging in any proprietary trading – with these exemptions (among others):

  • Trading in certain government obligations;
  • Underwriting and market making-related activities;
  • Risk-mitigating hedging activity; and
  • Trading on behalf of customers.

Thus the VR doesn’t have the concept of a trading or banking book, and focuses instead on exemptions to an overall prohibition against proprietary trading by banks.

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