The European Banking Authority (EBA) today published its final draft Regulatory Technical Standards (RTS) on the conditions for determining whether an instrument attracting residual risk acts as a hedge. These RTS are part of the Phase 1 deliverables of the EBA roadmap on the implementation of the EU banking package in the area of market risk.One of the pillars of the standardised approach/ sensitivity-based method (SA/SbM) under the new fundamental review of the trading book (FRTB) framework is the residual risk add-on (RRAO). The EU Banking Package introduces a provision in the RRAO framework allowing the exemption from the RRAO charge for those instruments bearing residual risks that are, in turn, used to hedge instruments bearing residual risks.These RTS specify when an instrument qualifies as a hedge for the purpose of the exemption and when not. In particular, the RTS require institutions to identify whether the RRAO charge for which the institution seeks the exemption relates to a risk factor that is not shocked in the SbM (i.e. a non-SbM risk factor), or if it is down to other reasons. When the RRAO relates exclusively to a non-SbM risk factor, the RTS envisage conditions aiming at assessing whether, as a result of the hedge, the sensitivity towards the non-SbM risk factor is reduced. Under this circumstance, constant-maturity spread plain vanilla options are should fall.A similar framework is applied to instruments referencing an exotic underlying in the form of dividend, future realised volatility or variance. On the other hand, where the RRAO charge is due to other reasons than the presence of a non-SbM risk factor, or an exotic underlying in the form of dividend, future realised volatility or variance, the RTS allow the hedging instrument to be recognised as hedge, and as such exempted from the RRAO charge, only if it completely offsets the RRAO risk stemming from the hedged instruments.Legal basis and backgroundThe draft RTS on the FRTB have been developed according to Article 325(u)(6) of Regulation (EU) No 575/2013 (CRR), as amended by the CRR3, which mandates the EBA to specify criteria to identify positions attracting residual risk that act as a hedge. In light of the postponement of the FRTB (), it is worth noting that these RTS are still needed for the implementation of the CRR as of 1 January, given that the FRTB-SA will apply for the purposes of the output floor calculation. The delivery of the RTS will, therefore, provide clarity on this aspect for the implementation of the EU Banking Package.
Brief
"On December 17, 2024, the European Banking Authority (EBA) issued an update regarding The EBA publishes final draft technical standards on the conditions for determining whether an instrument attracting residual risk acts as a hedge. These draft Regulatory Technical Standards (RTS) specify when an instrument qualifies as a hedge and when not, aiming to provide clarity on the exemption from the Residual Risk Add-on (RRAO) charge."
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Purpose:
The European Banking Authority (EBA) has published its final draft Regulatory Technical Standards (RTS) on the conditions for determining whether an instrument attracting residual risk acts as a hedge. The purpose of these RTS is to specify when an instrument qualifies as a hedge for the purpose of exemption from the Residual Risk Add-on (RRAO) charge, which is part of the Fundamental Review of the Trading Book (FRTB) framework.
The EBA’s goal in publishing these RTS is to provide clarity and consistency across EU banking institutions on how to identify hedges and exempt them from the RRAO charge. This will enable banks to accurately determine their capital requirements under the FRTB framework, which aims to improve the risk management of market risks.
Effects on Industry:
The publication of these RTS is expected to have a significant impact on the EU banking industry. Banks will need to reassess their hedging strategies and instruments to ensure compliance with the new standards. This may lead to changes in the way banks manage their residual risk, potentially affecting their capital requirements and overall financial stability.
The implementation of these RTS will also require banks to invest time and resources into updating their systems and processes to accurately identify hedges and apply the exemption from the RRAO charge. This may result in increased costs for banks, which could be passed on to consumers through higher fees or reduced services.
Relevant Stakeholders:
The relevant stakeholders affected by these RTS are:
- EU banking institutions subject to the FRTB framework
- Financial regulators and supervisors responsible for enforcing the new standards
- Market participants who rely on hedges to manage their residual risk, such as corporate treasurers and investors
These stakeholders will need to familiarize themselves with the new standards and make necessary adjustments to ensure compliance.
Next Steps:
To comply with these RTS, banks will need to:
- Review their hedging strategies and instruments to identify which ones qualify as hedges under the new standards
- Update their systems and processes to accurately apply the exemption from the RRAO charge for identified hedges
- Provide documentation to regulators and supervisors demonstrating compliance with the new standards
Financial regulators and supervisors will also need to update their guidelines and enforcement procedures to reflect the new standards.
Any Other Relevant Information:
The EBA’s publication of these RTS is part of its Phase 1 deliverables on the implementation of the EU banking package in the area of market risk. The FRTB framework aims to improve the risk management of market risks by introducing a standardized approach/sensitivity-based method (SA/SbM) and a residual risk add-on (RRAO).
The postponement of the FRTB deadline has meant that these RTS will still be relevant for the implementation of the CRR as of 1 January, even if the FRTB-SA is not yet fully implemented. The delivery of these RTS provides clarity on this aspect and ensures consistency across EU banking institutions.
