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Fundamental Review of the Trading Book and International Bond Markets


Andy Hill

Senior Director, Market Practice and Regulatory Policy, International Capital Market Association (ICMA) 

Andy Hill, Senior Director, Market Practice and Regulatory Policy at the International Capital Market Association (ICMA) discusses what FRTB means for bond markets, the implementation challenges and who will foot the bill.

What does FRTB mean for bond markets?

“If you thought that implementing MiFID II was expensive and resource intensive, FRTB turns the dial up a couple more notches. ICMA looks at how FRTB will make trading bonds more expensive.

“Essentially FRTB overhauls the way banks calculate and manage the risk related to their trading activities, and the amount of capital they need to support it. The result? A far greater degree of complexity in risk modelling and a need to source and process vast amounts of data to run the models. More significantly, it will increase the amount of capital that banks need to hold against their trading books.”

Implementation challenges

“There are many elements of FRTB that are challenging from an implementation perspective, but the two that seem to keep risk managers and traders awake at night relate to so-called “non-modellable risk factors” (NMRF) and the profit and loss (P&L) attribution test.

“NMRF demands sufficient ‘observable’ trade data for individual instruments to calculate the risk factors in banks’ models. Where there are gaps in the data, this creates an additional capital charge, a challenge for banks that trade less liquid (i.e. less traded) instruments, such as corporate bonds. Analysis suggests that for some banks, 60 per cent of their overall trading capital requirement could come from NMRF related charges.

“For banks to use their own internal risk models, individual trading desks need to ensure that their backward-looking desk-level P&L estimates (‘hypothetical P&L’) are consistent with the forward-looking P&L estimates predicted by their risk models (‘risk theoretical P&L’). If these deviate too much and too often, then the trading desk will be forced to apply the Basel III standardised approach (SA) to calculate their risk, which will generate a much higher capital charge.”

Investors and capital raisers will foot the bill

“Secondary bond markets rely on market-makers to function effectively. You can move all bond trading onto platforms, but if an asset manager or pension fund needs to sell bonds or buy new ones, most transactions will still require a market-maker to make them happen. That’s how bond markets work. So, the less willing or able bank broker-dealers are to provide intermediation services, the less liquid and efficient the market becomes.

“FRTB is set to increase the capital that banks will need to act as market-makers, and, not surprisingly, the less liquid the market, the greater the increase in capital is going to be. At best, this will need to be priced in to the bid-asks of market-makers, and, in the worst case, many banks may be forced to review their trading activities and withdraw intermediation services for more capital-intensive products and markets. Ultimately investors and capital raisers will foot the bill.”

A welcome delay

“Given the implementation challenges, and some ambiguities around the more complex aspects of the regulation, delaying to 2022 is very much welcomed by the industry.

“Apart from giving banks more time to adapt their risk architecture, it may allow for a review of the regulation and potential recalibration of some of its more problematic elements. In one form or another, FRTB is still going to happen, and market-making for bonds and other financial instruments is going to become more complicated and a lot more expensive for banks, investors and issuers.”

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