- European technical standards on assessing risk factor modelability provide welcome clarity on which committed quotes are eligible for inclusion in the FRTB RFET.
- The draft rules stipulate quotes must have both a bid and offer on the same day — although not necessarily from the same party.
- While the European Banking Authority (EBA) is understandably keen to ensure only sound prices are taken into account when calculating the RFET, we must also consider the role of committed quotes and the wider implications on market structure.
1. Marketing operating using single sided quote
Markets that operate using single-sided quotes won’t have access to much of the quote data, and so could be unfairly penalized.
Many traditional OTC markets trade using a request for quote protocol. Under these systems a customer can specify whether they are seeking to buy or sell the instrument, and dealers respond by providing a single-sided quote.
At no point in the workflow is a two-sided committed quote, which includes a bid and offer, made available to the client, the market or the public.
Under the EBA’s proposed rules, these markets will only be able to use quotes where individual bid quotes and individual offer quotes are published on the same day.
In markets such as corporate bonds, there are a very large number of instruments outstanding, but a very small proportion of these trade on a given day. It is unlikely that an instrument will experience sufficient interest to have both bid and offer quotes on the same day, but not trade.
Defining committed quotes so they are largely inaccessible to markets that operate using single-sided committed quotes will reduce the proportion of modelable risk factors. This approach will also likely increase the capital buffer that banks need to hold.
Such a requirement could create a negative feedback loop leading to further liquidity withdrawal, potentially resulting in a sub-optimal level of market activity.
2. MiFID II pre-trade data
The use of pre-trade data from Europe’s largest transparency initiative, MiFID II, will be limited as an input into RFET.
We analyzed a sample of bond and derivatives quotes published under the MiFID II regulation. The data (see below) shows once quotes have been processed so only a single observation per instrument per day is taken into account (as per required by the regulation), only 11 percent of the observations have both a bid and offer in the same instrument on the same day.
Table 1: Summary of MiFID II quote data by asset class
If the majority of MiFID II pre-trade data in OTC markets is considered ineligible for inclusion in RFET, it could put a greater reliance on banks’ own internal data and increase the likelihood of non-modelability.
Larger banks that have access to more internal RPO data could have an advantage over their smaller rivals in terms of passing the RFET.
3. The BCBS FRTB rules
A potential inconsistency with the original BCBS requirement.
The Basel Committee on Banking Supervision (BCBS) FRTB rules published in 2019 state: “A committed quote is a price from an arm’s length provider at which the provider of the quote must buy or sell the financial instrument.”
Such a requirement appears to be inconsistent with the EBA’s rule to require quote data to include both a bid and an offer.
If the European Union (EU) implements a stricter definition of committed quotes than other jurisdictions, this could cause EU-based banks to be less likely to pass RFET.
This scenario could also result in higher capital requirements than comparable banks holding similar levels of market risk in other jurisdictions, where the regulator follows the BCBS requirements.