• PRU APP2 PRU APP2 GENERAL REQUIREMENTS

    • PRU A2.1 PRU A2.1 Detail in the Trading Book

      • PRU A2.1.1

        (1) This Appendix applies to an Authorised Person which meets the criteria in Rule 2.2.1 and is thereby required to have a Trading Book.
        (2) An Authorised Person which is required to have a Trading Book must:
        (a) have a Trading Book policy in accordance with Section A2.2; and
        (b) include positions in its Trading Book on a consistent basis in accordance with the policy and procedures set out in the Trading Book policy.
        (3) An Authorised Person must include every position that is not included in its Trading Book in its Non-Trading Book.
        (4) An Authorised Person must value every position included in its Trading Book and the Non-Trading Book in accordance with the relevant accounting standards and practices.

      • Value of Trading Book positions

        • PRU A2.1.2

          (1) In calculating the value of positions for the purposes of Rule 2.2.1(c) an Authorised Person must value:
          (a) equities and debt instruments at their market prices;
          (b) Derivatives according to the values of the underlying; and
          (c) Underwriting positions according to the market value of the underlying Securities.
          (2) An Authorised Person must sum all long and short positions (ignoring the sign) to calculate its total Trading Book size.

      • Positions included in the Trading Book

        • PRU A2.1.3 PRU A2.1.3

          An Authorised Person must include in its Trading Book, subject to the Rules on trading intent and hedging Non-Trading Book Exposures:

          (a) each proprietary position in a Financial Instrument, commodity or commodity Derivative which is held with trading intent as detailed in Rule A2.1.5(3);
          (b) each position arising from Matched Principal broking and market making;
          (c) each position taken in order to hedge another element of the Trading Book;
          (d) each Exposure due to a repurchase agreement (repo), or Securities and commodities lending, which is based on a Security or commodity included in the Trading Book;
          (e) each Exposure due to a reverse repurchase agreement (reverse repo), or Securities and commodities borrowing transaction included in the Trading Book;
          (f) each Exposure arising from an Unsettled Transaction, free delivery or OTC Derivative; and
          (g) each Exposure in the form of a fee, commission, interest, dividend or margin on an exchange-traded Derivative directly related to the items included in the Trading Book.

          • Guidance

            Whenever an Authorised Person acts as principal (even in the context of activity normally described as 'broking' or 'customer business'), positions should be assigned to the Trading Book. This applies even if the nature of the business means that the only risks being incurred by the Authorised Person are Counterparty Risks (that is, no Market Risk Capital Requirements apply).

        • PRU A2.1.4

          (a) An Authorised Person must not include loans or traded loans in its Trading Book unless they have been used to hedge a Trading Book transaction.
          (b) An Authorised Person must not include in its Trading Book an Exposure relating to a direct holding of immovable property.

      • Trading intent

        • PRU A2.1.5

          (1) An Authorised Person must, subject to Rule A2.1.3, only include in its Trading Book:
          (a) a position in a Financial Instrument, commodity or commodity Derivative held with trading intent; or
          (b) a position hedging other positions in the Trading Book.
          (2) For the purpose of (1), such positions included in the Trading Book must be free of any restrictive covenants which limit their tradability or ability to be hedged.
          (3) For the purpose of (1), a position in a Financial Instrument, commodity or commodity Derivative is held with trading intent if:
          (a) it is held with the intention of:
          (i) benefiting in the short term from actual or expected differences between buying and selling prices or from other price or interest-rate variations;
          (ii) selling it over the short term;
          (iii) locking in arbitrage profits; or
          (iv) market making;
          (b) it is marked to market or marked to model regularly on a prudent and consistent basis, as part of the Authorised Person's internal risk management processes;
          (c) position-takers at the Authorised Person have autonomy in entering into or changing transactions within pre-determined limits, or the position satisfies other criteria which the Authorised Person applies to the composition of its Trading Book;
          (d) there is an appropriate documented trading strategy for the position, approved by senior management which includes the expected holding horizon; and
          (e) active monitoring of the position is undertaken using market information sources.

        • PRU A2.1.6

          Positions held with trading intent must comply with the following requirements:

          (a) trading intent must be evidenced in the strategies, policies and procedures established by the Authorised Person to manage the position or its portfolio;
          (b) there must be clearly defined policies and procedures for active management of the position to ensure the following:
          (i) the position is entered and/or managed on a trading desk;
          (ii) position limits are set and monitored for appropriateness;
          (iii) position-takers at the Authorised Person have autonomy in entering into or changing transactions within pre-determined limits, or the position satisfies other criteria which the Authorised Person applies to the composition of its Trading Book;
          (iv) the position is marked-to-market or marked-to-model at least daily on a prudent and consistent basis as part of the Authorised Person's internal risk management processes;
          (v) where the position is marked-to-model, the parameters for the model are assessed on a daily basis;
          (vi) the position is monitored against the documented trading strategy including the monitoring of turnover and stale positions in the Authorised Person's Trading Book;
          (vii) active monitoring of the position is undertaken using market information sources and an assessment made of the marketability or hedge-ability of the position or its component risks, including the assessment of the quality and availability of market inputs to the valuation process, level of markets turnover and sizes of positions traded in the market; and
          (viii) positions and exceptions are reported to senior management as an integral part of the risk management process of the Authorised Person.

      • Treatment of structural foreign exchange positions

        • PRU A2.1.7

          An Authorised Person in Category 1 or 5 which has assumed a position in order to hedge partially or totally against the adverse effect of the exchange rate on its Capital Resources, in respect of an asset or any other item, may exclude such a position from the calculation of its net open foreign exchange positions subject to the following:

          (a) the position is of a non-dealing nature;
          (b) the position does no more than protect the Capital Resources of the Authorised Person; and
          (c) any exclusion of the position is applied consistently, with the treatment of the hedge remaining the same for the life of the asset or other item.

        • PRU A2.1.8

          In calculating its net open foreign exchange positions, an Authorised Person may exclude any foreign exchange position related to:

          (a) items which are included as deductions from T1 Capital or deductions from T2 Capital, such as investments in unconsolidated subsidiaries; and
          (b) associated companies and joint ventures, denominated in foreign currencies, which are reported in the published accounts of an Authorised Person at historic cost.

      • Repurchase and reverse repurchase agreements

        • PRU A2.1.9 PRU A2.1.9

          An Authorised Person must include in its Trading Book an Exposure due to a repurchase agreement, reverse repurchase agreement, Securities and commodities borrowing, or Securities and commodities lending transactions if:

          (a) the Exposure is marked to market daily (cash borrowed or lent under a repurchase agreement or a reverse repurchase agreement may be included in the Trading Book even if not marked to market provided that the residual maturity of the borrowing or lending is one month or less);
          (b) the Collateral is adjusted to take account of changes in the value of the Securities or commodities involved;
          (c) the agreement or transaction provides for the Authorised Person's claims to be automatically and immediately offset against its Counterparty's claims if the latter defaults; and
          (d) such agreements and transactions are confined to their accepted and appropriate use and artificial transactions, especially those not of a short-term nature, are excluded.

          • Guidance

            Cash items include loans and Deposits and the cash legs of repurchase, stock borrowing, reverse repurchase and stock lending transactions. The Trading Book treatment for such Exposures is set out in Rule A4.7.

        • PRU A2.1.10 PRU A2.1.10

          Where the conditions under Rule A2.1.9 are not met, an Authorised Person must, subject to Rule A2.1.3, include an Exposure arising under a repurchase agreement, reverse repurchase agreement, Securities and commodities borrowing or Securities and commodities lending in its Non-Trading Book.

          • Guidance

            The Non-Trading Book treatment for such Exposures is set out in Rules in A4.8 and A4.9.

      • Hedging of a Trading Book Exposure by a non-Financial Instrument

        • PRU A2.1.11 PRU A2.1.11

          (1) An Authorised Person may hedge a Trading Book Exposure, completely or partially, by a non-Financial Instrument that is not listed in A2.1.3. The General Market Risk Exposure associated with the non-Financial Instrument may be incorporated into the calculation of General Market Risk in the Trading Book if:
          (a) the specific instrument is used to hedge an Exposure in an Authorised Person's Trading Book;
          (b) the hedge position satisfies the Netting rules contained in the relevant Sections of the Market Risk Chapter; and
          (c) the hedge position is marked to market or marked to model and is valued regularly on a prudent and consistent basis.
          (2) For the purposes of (1), the non-Financial Instrument must be treated as attracting capital charges as if it were a Financial Instrument.

          • Guidance

            1. If the conditions for incorporating non-Financial Instruments in the calculation of General Market Risk in the Trading Book under Rule A2.1.11 are not met, they will be treated as Non-Trading Book items.
            2. For the purposes of Section A2.1, a loan will attract General Market Risk (see Chapter 5) and Counterparty Risk (see Chapter 4) on the marked-to-market valuation.

        • PRU A2.1.12 PRU A2.1.12

          (1) If an internal hedge meets the criteria specified in (2), an Authorised Person may include it in the Trading Book without prejudice to the Capital Requirement application to the Non-Trading Book "leg" of the internal hedge.
          (2) Positions arising from internal hedges are eligible for Trading Book capital treatment, provided that they meet the criteria for trading intent specified in Rule A2.1.5 and the following criteria on prudent valuation:
          (a) the internal hedge is not primarily intended to avoid or reduce Capital Requirements which the Authorised Person would be otherwise required to maintain;
          (b) the internal hedge is properly documented and subject to specific internal approval and audit procedures;
          (c) the internal hedge is dealt with at market conditions;
          (d) the bulk of the Market Risk which is generated by the internal hedge is dynamically managed in the Trading Book within the limits approved by senior management; and
          (e) the internal hedge is carefully monitored with adequate procedures.
          (3) Where an Authorised Person hedges a Non-Trading Book Exposure using a Credit Derivative booked in the Trading Book, the Non-Trading Book Exposure is not deemed to be hedged for the purpose of calculating its regulatory Capital Requirement, unless the Authorised Person purchases from an eligible protection provider a Credit Derivative which complies with the requirements and meets the guidelines set out in the relevant Section of Chapter 4. Where eligible credit protection is purchased and is recognised as a hedge of the Non-Trading Book Exposure for the purpose of calculating its regulatory Capital Requirement, the Authorised Person may exclude both the internal and external Credit Derivative hedge from the Trading Book for the purpose of calculating its regulatory Capital Requirement for the period of the hedge.

          • Guidance

            An internal hedge is a position that materially or completely offsets the component risk element of a Non-Trading Book position or a set of positions.

      • Transfer of General Market Risk between the Trading Book and the Non-Trading Book

        • Guidance

          1. General Market Risk arising from the Trading Book may hedge Non-Trading Book positions without reference to specific Financial Instruments.
          2. An Authorised Person may achieve the transfer of General Market Risk between the Trading Book and Non-Trading Book by entering into a notional legal agreement between the Trading Book and Non-Trading Book as if they were third parties.

        • PRU A2.1.13 PRU A2.1.13

          An Authorised Person must ensure that:

          (a) a transfer of General Market Risk between its Trading Book and Non-Trading Book is subject to appropriate documentation and evidenced by a clear audit trail;
          (b) positions held in its Non-Trading Book that are being hedged by General Market Risk arising from positions in the Trading Book remain in the Non-Trading Book; and
          (c) the General Market Risk Exposure associated with the positions in the Non-Trading Book is incorporated into the calculation of General Market Risk in the Trading Book.

          • Guidance

            An example of the application of Rule A2.1.13(c) is as follows:

            a. An Authorised Person may have a fixed-rate loan portfolio in the Non-Trading Book. Although the Non-Trading Book does not attract a regulatory capital charge for interest rate risk, the portfolio is subject to interest rate risk. Firms may prefer to transfer this risk to the Trading Book where it may be actively managed.
            b. The Authorised Person may transfer this interest rate risk by entering into, for example, a fixed versus floating rate swap between the Trading Book and the Non-Trading Book. The notional long and short positions created as result of the swap are recorded in the Trading Book, and the swap positions may be treated as Financial Instruments provided that appropriate documentation is in place (see Rule A2.1.14). The General Market Risk requirements associated with the swap legs are allocated to the appropriate Trading Book General Market Risk bucket and thus may reduce the overall General Market Risk requirement in the Trading Book.
            c. For an Authorised Person to undertake such a transaction there should be existing positions in the Trading Book, which result in a sufficient General Market Risk requirement to offset the General Market Risk created as a result of the swap.

        • PRU A2.1.14 PRU A2.1.14

          Appropriate documentation under A2.1.13 must cover:

          (a) details of the instruments or Exposures being transferred and the method used to transfer; and
          (b) the pricing of the transfer.

          • Guidance

            1. Separate documentation need not be produced for every transfer. If the same method is used for a number of transfers, a single document detailing the procedures will suffice. However, an Authorised Person must still be able to distinguish transactions that have been undertaken for risk transfer purposes from other transactions.
            2. Arm's-length prices must be used in any transfer. 'Arm's-length' means the prevailing market price for the particular transaction.

    • PRU A2.2 PRU A2.2 Trading Book Policy

      • Guidance

        The requirement for a Trading Book policy is prescribed in Rule A2.1.1.

      • PRU A2.2.1

        A Trading Book policy must include clearly defined policies, procedures and methodologies by which the Authorised Person:

        (a) defines its Trading Book and identifies positions to be included in its Trading Book;
        (b) allocates positions between the Non-Trading Book and the Trading Book;
        (c) actively manages and values its positions in the Trading Book;
        (d) measures its Trading Book risks; and
        (e) controls transfers of positions between the Non-Trading Book and the Trading Book.

      • PRU A2.2.2

        An Authorised Person must obtain the prior written approval of its Governing Body for its Trading Book policy. The Authorised Person must review and where necessary update the policy at least annually. The Authorised Person must obtain the prior written approval of the Governing Body for all significant changes.

      • PRU A2.2.3 PRU A2.2.3

        An Authorised Person must, without undue delay, notify the Regulator when its Governing Body approves the adoption of a Trading Book policy or approves any changes to the policy.

        • Guidance

          1. At a minimum, the Regulator expects that a Trading Book policy will address the following:
          a. the definition of Trading Book and trading strategy, including:
          i. the activities that the Authorised Person considers to be trading and the types of positions that are to be allocated to the Trading Book for the purposes of calculating its regulatory Capital Requirements;
          ii. the types of positions that are excluded from the Trading Book; and
          iii. the procedures to ensure that the criteria by which positions are allocated to the Trading Book are adhered to on a consistent basis, including details on:
          A. the organisational unit or department within the Authorised Person responsible for monitoring adherence to the Trading Book policy;
          B. the frequency of monitoring;
          C. process and methodology of this monitoring; and
          D. how the continuing appropriateness of allocations is confirmed;
          b. the extent of active management and valuation, including:
          i. the extent to which a position can be marked-to-market daily by reference to an active, liquid two-way market;
          ii. for positions which are marked-to-model, the extent to which the Authorised Person can:
          A. identify all the material risks of the position;
          B. hedge the material risks of the position and, where the material risks of the position are hedged, the extent to which hedging instruments used have an active and liquid two-way market; and
          C. derive reliable external estimates for the key assumptions and parameters used in the model;
          iii. the extent to which the Authorised Person can, and is required to, generate valuations for the position which can validated externally by its Auditors or by the Regulator in a consistent manner;
          iv. the extent to which the Authorised Person can, and is required to, maintain documents to support valuations of its Trading Book positions;
          v. the basis for determining and maintaining valuation adjustments for the purposes of calculating regulatory Capital Requirements;
          vi. the extent to which legal restrictions or other operational requirements would impede the ability of the Authorised Person to effect an immediate liquidation of the position; and
          vii. the extent to which the Authorised Person can, and is required to, actively risk manage a position within its trading operations;
          c. transfers between Non-Trading and Trading Books, including:
          i. the extent to which an Authorised Person may transfer positions between the Non-Trading Book and the Trading Book and the criteria for such transfers;
          ii. the procedures to effect such transfers; and
          iii. the controls in place to prevent inappropriate transfers of positions between the Non-Trading Book and the Trading Book; and
          d. the following additional considerations:
          i. whether there are any subsidiaries or offshore branches of the Authorised Person undertaking transactions to be included in the Trading Book. If so, a list of such subsidiaries or branches shall be included, along with a description of the trading activities carried out by such entities;
          ii. the treatment of inter-desk deals; and
          iii. the identification and management of structural foreign exchange positions.
          2. An Authorised Person should prepare its Trading Book policy on a consolidated basis where the Financial Group either manages its trading risk centrally or employs the same risk management techniques across all the entities in the Financial Group. Where a Trading Book policy is prepared on a consolidated basis, an Authorised Person should ensure that its application to the Authorised Person and each of the other entities in the Financial Group is made clear and approved by the Governing Body of the Authorised Person and the Governing Body of each of those entities.

    • PRU A2.3 PRU A2.3 Risk management systems and controls for Trading Book

      • PRU A2.3.1

        An Authorised Person must establish and maintain effective systems and controls to manage its Trading Book.

      • PRU A2.3.2

        An Authorised Person must establish and maintain systems and controls sufficient to provide prudent and reliable valuation estimates. These systems and controls must include:

        (a) documented policies and procedures for the process of valuation (including clearly defined responsibilities of the various areas involved in the determination of the valuation, sources of market information and review of their appropriateness, frequency of independent valuation, timing of closing prices, procedures for adjusting valuations, month end and ad-hoc verification procedures); and
        (b) reporting lines for the department accountable for the valuation process that are clear and independent of the front office.

    • PRU A2.4 PRU A2.4 Reporting to the Regulator

      • PRU A2.4.1

        The forms to be used by Authorised Persons for the purpose of reporting under these Rules are set out in EPRS.

    • PRU A2.5 PRU A2.5 Prudent Valuation Practices

      • Guidance

        1. This following guidance sets out the Regulator's expectations for prudent valuation practices, including adequate systems and controls and valuation methodologies, for the purpose of Section 2.4 of these Rules.

      • Systems and controls

        2. Authorised Persons should establish and maintain adequate systems and controls sufficient to give management and the Regulator the confidence that their valuation estimates are prudent and reliable. These systems should be integrated with other risk management systems within the organisation (such as credit analysis). Such systems are expected to include:
        a. documented policies and procedures for the process of valuation. This includes clearly defined responsibilities of the various areas involved in the determination of the valuation, sources of market information and review of their appropriateness, guidelines for the use of unobservable inputs reflecting the Authorised Person's assumptions of what market participants would use in pricing the position, frequency of independent valuation, timing of closing prices, procedures for adjusting valuations, end of the month and ad-hoc verification procedures; and
        b. clear and independent (i.e. independent of front office) reporting lines for the department accountable for the valuation process. The reporting line should ultimately be to a main board executive Director or equivalent.

      • Valuation methodologies

        • Marking-to-market

          3. Marking-to-market is at least the daily valuation of positions at readily available close out prices in orderly transactions that are sourced independently. Examples of readily available close out prices include exchange prices, screen prices, or quotes from several independent reputable brokers.
          4. Authorised Persons should mark-to-market as much as possible. The more prudent side of bid/offer should be used unless the institution is a significant market maker in a particular position type and it can close out at mid-market. Authorised Persons should maximise the use of relevant observable inputs and minimise the use of unobservable inputs when estimating fair value using a valuation technique. However, observable inputs or transactions may not be relevant, such as in a forced liquidation or distressed sale, or transactions may not be observable, such as when markets are inactive. In such cases, the observable data should be considered, but may not be determinative.

        • Marking-to-Model

          5. Only where marking-to-market is not possible should Authorised Persons mark-to-model, but in such cases, the Authorised Person should be able to demonstrate to the Regulator that the approach is prudent. Marking-to-model is defined as any valuation which has to be benchmarked, extrapolated or otherwise calculated from a market input. When marking-to-model, an extra degree of conservatism is appropriate. The Regulator will consider the following in assessing whether a mark-to-model valuation is prudent:
          a. senior management should be aware of the elements of the Trading Book or of other fair-valued positions which are subject to mark-to-model and should understand the materiality of the uncertainty this creates in the reporting of the risk/performance of the business;
          b. market inputs should be sourced, to the extent possible, in line with market prices (as discussed above). The appropriateness of the market inputs for the particular position being valued should be reviewed regularly;
          c. where available, generally accepted valuation methodologies for particular products should be used as far as possible;
          d. where the model is developed by the Authorised Person itself, it should be based on appropriate assumptions, which have been assessed and challenged by suitably qualified parties independent of the development process. The model should be developed or approved independently of the front office. It should be independently tested. This includes validating the mathematics, the assumptions and the software implementation;
          e. there should be formal change control procedures in place and a secure copy of the model should be held and periodically used to check valuations;
          f. risk management should be aware of the weaknesses of the models used and how best to reflect those in the valuation output;
          g. the model should be subject to periodic review to determine the accuracy of its performance (e.g. assessing continued appropriateness of the assumptions, analysis of profit and loss versus risk factors, comparison of actual close out values to model outputs); and
          h. valuation adjustments should be made as appropriate, for example, to cover the uncertainty of the model valuation (see also valuation adjustments in Guidance notes 6 to 14.)

        • Independent price verification

          6. Independent price verification is distinct from daily mark-to-market. It is the process by which market prices or model inputs are regularly verified for accuracy. While daily marking-to-market may be performed by dealers, verification of market prices or model inputs should be performed by a unit independent of the dealing room, at least monthly (or, depending on the nature of the market/trading activity, more frequently). It need not be performed as frequently as daily mark-to-market, since the objective, i.e. independent, marking of positions should reveal any error or bias in pricing, which should result in the elimination of inaccurate daily marks.
          7. Independent price verification entails a higher standard of accuracy in that the market prices or model inputs are used to determine profit and loss figures, whereas daily marks are used primarily for management reporting in between reporting dates. For independent price verification, where pricing sources are more subjective, e.g. only one available broker quote, prudent measures such as valuation adjustments may be appropriate.

        • Valuation adjustments

          8. As part of their procedures for marking-to-market, Authorised Persons should establish and maintain procedures for considering valuation adjustments. The Regulator expects Authorised Persons using third-party valuations to consider whether valuation adjustments are necessary. Such considerations are also necessary when marking-to-model.
          9. The Regulator expects the following valuation adjustments to be formally considered at a minimum: unearned credit spreads, close-out costs, Operational Risks, early termination, investing and funding costs, and future administrative costs and, where appropriate, model risk.

        • Adjustment to the current valuation of less liquid positions for regulatory capital purposes

          10. Authorised Persons should establish and maintain procedures for judging the necessity of and calculating an adjustment to the current valuation of less liquid positions for regulatory capital purposes. This adjustment may be in addition to any changes to the value of the position required for financial reporting purposes and should be designed to reflect the illiquidity of the position. The Regulator expects Authorised Persons to consider the need for an adjustment to a position's valuation to reflect current illiquidity whether the position is marked-to-market using market prices or observable inputs, third-party valuations or marked-to-model.
          11. Bearing in mind that the assumptions made in relation to calculating VaR may not be consistent with the Authorised Person's ability to sell or hedge out less liquid positions, where appropriate, Authorised Persons should take an adjustment to the current valuation of these positions, and review their continued appropriateness on an on-going basis. Reduced liquidity may have arisen from market events. Additionally, close-out prices for concentrated positions and/or stale positions should be considered in establishing the adjustment.
          12. Authorised Persons should consider all relevant factors when determining the appropriateness of the adjustment for less liquid positions. These factors may include, but are not limited to, the amount of time it would take to hedge out the position/risks within the position, the average volatility of bid/offer spreads, the availability of independent market quotes (number and identity of market makers), the average and volatility of trading volumes (including trading volumes during periods of market stress), market concentrations, the aging of positions, the extent to which valuation relies on marking-to-model, and the impact of other model risks not included in Guidance note 10.
          13 For complex products including, but not limited to, securitisation Exposures and nth-to-default Credit Derivatives, Authorised Persons who are approved to use models to calculate Market Risk should explicitly assess the need for valuation adjustments to reflect two forms of model risk: the model risk associated with using a possibly incorrect valuation methodology; and the risk associated with using unobservable (and possibly incorrect) calibration parameters in the valuation model.
          14. The adjustment to the current valuation of less liquid positions made under Guidance note 11 is likely to impact minimum Capital Requirements and may exceed those valuation adjustments made under the International Financial Reporting Standards and Guidance notes 8 and 9.