Fundamental Review of the Trading Book (FRTB)

The Fundamental Review of the Trading Book (FRTB) is a comprehensive set of Market Risk regulatory capital standards developed by the Basel Committee for Banking Supervision (BCBS). They are a part of the Basel III package of reforms, which are designed to address a number of shortcomings identified in the Basel II framework as a result of the Global Financial Crisis of 2008.

The new standards seek to tighten the criteria for measuring market risk exposure by creating a firmer boundary around the scope of the trading book and by improving rules banks use when calculating the amount of regulatory capital they must hold, based on their market risk exposure.

The enforcement date set by the Basel Committee was 1 January 2023. However, individual jurisdictions have to translate FRTB into their own banking rulebooks before they can be enforced. Regulators in those jurisdictions can tweak FRTB to reflect local conditions, and they can also change the implementation deadline.

While some of the bigger jurisdictions at global level have set their deadlines (e.g. EU, which will go live on 1 Jan 2025), others have yet to set them so it’s important to check with the applicable regulator directly about the implementation deadline. 

The data required for FRTB compliance is, generally speaking, much more granular in nature than under the previous Basel Committee market risk framework. For example:

• Banks will need to perform capital requirements calculations at the trading desk level.
• There are much stricter rules about instruments eligible to go to the banking book versus the trading book.
• The standardised and internal models approach for the capital requirements calculations are more complex than in the previous regulatory regime. 

The Standardised Approach (SA) is a standard market risk methodology for capital requirements calculation. The FRTB rules prescribe that capital requirements at desk level under the SA are calculated by summing up three components:

• The capital requirement under the Sensitivities based Method (SBM)
• The Default Risk Capital (DRC) requirement
• The Residual Risk Add-On (RRAO)

All banks have to implement the SA for all their desks, regardless if any of their trading desks will implement the Internal Model Approach methodology and is considered less resource-intensive to use than the Internal Models Approach. 

For the Funds Look-Through Approach, the FRTB rules say that equity investments in funds will need to be treated apart so that the underlying positions of the fund are transparent. Then, these underlying positions will need to be treated as if they were held directly by the bank for the purpose of calculating the relevant sensitivities. So, under the new requirements, banks will need to get access to the funds holding and weights.

The Index Look Through Approach is similar to the Funds Look Through Approach, but designed for index instruments. Banks will need to access individual constituents and weights of an index, to treat the underlying positions as if they were held directly by the bank.

LSEG provides data fields at instrument level to support banks in the calculation of the Sensitivities Based Method, made available via DataScope Select and DataScope Plus.

For more information download our Standardised Approach factsheet.

The Internal Models Approach (IMA) is the second method banks can use to calculate market risk capital, and to use it banks need to apply for permission from their regulator.

The FRTB introduced substantial changes to the previous internal models approach, in part because of market risk issues that arose during the Financial Crisis of 2008. For example, the new IMA requirements specify stricter criteria to make trading desks eligible to the IMA, as they have now to pass quantitative and qualitative tests. Additionally, the new FRTB includes a new market risk metric for capital requirements calculation, greater sensitivity to market illiquidity and model approval at the trading desk level. These changes are so great that banks will need to apply for a new approval of their Internal Models Approach.

Banks that apply for the IMA status will need to assess the liquidity of the risk factors used in their models as designed under the risk factor eligibility test requirements. 

The Risk Factor Eligibility Test (RFET) is a liquidity test for risk factors at trading desk level. It has been designed to identify which risk factors will use the expected shortfall methodology for the capital requirements calculation and those that will be processed under a different methodology which will result in much higher capital charges.

In order to pass the RFET, banks must source records of executed trades and committed quote data (collectively known as “Real Price Observations” or RPOs) for the previous year, attribute the trades to individual risk factors, and check whether there is sufficient trading activity to pass predefined liquidity thresholds.

LSEG can help you on the risk factor eligibility test by providing regulatory-compliant ‘real’ price observation data on a broad range of instruments to enable you to fulfil the Risk Factor Eligibility Test compliance requirement.

Our Trade Discovery solution delivers data from a variety of sources, including regulated markets, “transparent” OTC markets and “opaque” OTC markets by partnering with the most established market infrastructure providers, such as the LCH and Tradeweb.

For more information download our Internal Models Approach factsheet.