5.The capital charges, as explained below, for interest rate related instruments and equities would apply to the trading book. The capital charges for foreign exchange risk and for commodities risk will apply to banks’ total currency and commodity positions.

6.Banks must have clearly defined policies and procedures for determining which exposures to include in, and to exclude from, the trading book for purposes of calculating their regulatory capital, to ensure compliance with the criteria for trading book set forth in this Standard and taking into account the bank’s risk management capabilities and practices. These policies and procedures must be fully documented and subject to periodic internal audit, and at a minimum address the general considerations listed below:

• •The activities the bank considers to be trading and as constituting part of the trading book for regulatory capital purposes;
• •The extent to which an exposure can be marked-to-market daily by reference to an active, liquid two-way market;
• •For exposures that are marked-to-model, the extent to which the bank can:
  • –Identify the material risks of the exposure;
  • –Hedge the material risks of the exposure and the extent to which hedging instruments would have an active, liquid two-way market;
  • –Derive reliable estimates for the key assumptions and parameters used in the model.
• •The extent to which the bank can and is required to generate valuations for the exposure that can be validated externally in a consistent manner;
• •The extent to which legal restrictions or other operational requirements would impede the bank’s ability to effect an immediate liquidation of the exposure;
• •The extent to which the bank is required to, and can, actively risk manage the exposure within its trading operations; and
• •The extent to which the bank may transfer risk or exposures between the banking and the trading books and criteria for such transfers.

7.The following will be the basic requirements for positions eligible to receive trading book capital treatment:

• •Clearly documented trading strategy for the position/instrument or portfolios, approved by senior management (which would include expected holding horizon);
• •Clearly defined policies and procedures for the active management of the position, which must include;
  • –positions are managed on a trading desk;
  • –position limits are set and monitored for appropriateness;
  • –dealers have the autonomy to enter into/manage the position within agreed limits and according to the agreed strategy;
  • –positions are marked to market at least daily and when marking to model the parameters must be assessed on a daily basis;
  • –positions are reported to senior management as an integral part of the institution’s risk management process; and
  • –positions are actively monitored with reference to market information sources (assessment should be made of the market liquidity or the ability to hedge positions or the portfolio risk profiles). This would include assessing the quality and availability of market inputs to the valuation process, level of market turnover, sizes of positions traded in the market, etc; and
• •Clearly defined policy and procedures to monitor the positions against the bank’s trading strategy including the monitoring of turnover and stale positions in the bank’s trading book.

8.Term trading-related repo-style transactions that meet the requirements for trading- book treatment as stated in the paragraph above may be included in the bank’s trading book for regulatory capital purposes even if a bank accounts for those transactions in the banking book. If the bank does so, all such repo-style transactions must be included in the trading book, and both legs of such transactions, either cash or securities, must be included in the trading book. Regardless of where they are booked, all repo-style transactions are subject to a credit risk capital requirement under the Central Bank’s Standard for Credit Risk Capital.

9.When a bank hedges a banking book credit risk exposure using a credit derivative booked in its trading book (i.e. using an internal hedge), the banking book exposure is not deemed to be hedged for capital purposes unless the bank purchases from an eligible third party protection provider a credit derivative meeting the requirements in the Central Bank’s Standard for Credit Risk Capital. Where such third party protection is purchased and is recognized as a hedge of a banking book exposure for regulatory capital purposes, neither the internal nor external credit derivative hedge would be included in the trading book for regulatory capital purposes.

10.Positions in the bank’s own eligible regulatory capital instruments are deducted from capital. Positions in other banks’, securities firms’, and other financial entities’ eligible regulatory capital instruments, as well as intangible assets, will receive the same treatment as that set down by the Central Bank for such assets held in the banking book. Where a bank demonstrates to the Central Bank that it is an active market maker, then the Central Bank may establish a dealer exception for holdings of other banks’, securities firms’, and other financial entities’ capital instruments in the trading book. In order to qualify for the dealer exception, the bank must have adequate systems and controls surrounding the trading of financial institutions’ eligible regulatory capital instruments.

11.For the purposes of these Standards, the correlation trading portfolio incorporates securitisation exposures and nth-to-default credit derivatives that meet the following criteria:

• •The positions are neither resecuritisation positions, nor derivatives of securitisation exposures that do not provide a pro-rata share in the proceeds of a securitisation tranche; and
• •All reference entities are single-name products, including single-name credit derivatives, for which a liquid two-way market exists. This includes commonly traded indices based on these reference entities. Positions that reference an underlying that would be treated as a retail exposure, a residential mortgage exposure, or a commercial mortgage exposure under the standardized approach to credit risk are not included in the correlation-trading portfolio. Positions that reference a claim on a special purpose entity also are not included. A bank may include in the correlation trading portfolio positions that are hedges of securitisation exposures or nth-to-default credit derivatives, but that are not themselves either securitisation exposures or nth-to-default credit derivatives, where a liquid two-way market exists for the instrument or its underlying.