Requirements for use of own-estimate haircuts
An Authorised Person using own-estimate haircuts must estimate the volatility for each individual instrument that is taken as eligible financial Collateral. In estimating such volatility, the Authorised Person must not take into account the correlations between unsecured Exposures, Collateral and exchange rates. Where there are Maturity Mismatches, the Authorised Person must apply Rules 4.13.14 to 4.13.16.
An Authorised Person must ensure that the model used to estimate volatilities captures all the material risks run by it.
PRU A4.3.22 PRU A4.3.22
In calculating the haircuts using internal estimates of volatilities, an Authorised Person must:(a) use a 99th percentile, one-tailed confidence interval;(b) use the minimum holding period and remargining or revaluation conditions according to the type of transaction as set out in Rules A4.3.24 to A4.3.26. Where the minimum holding period, remargining or revaluation conditions used by an Authorised Person differ from those set out above, it must adjust the haircuts using the formulae in Rules A4.3.25 to A4.3.26;(c) use a historical observation period (i.e. sample period) of at least one year.
Where the Authorised Person uses a weighting scheme or other methods for the historical observation period, the "effective" observation period must be at least one year (i.e. the weighted average time lag of the individual observations must not be less than six months);(d) update its data sets at least once every three months and recalculate haircuts at least once every three months. The Regulator may require more frequent updates whenever there is an increase in volatility in market prices of the Collateral; and(e) use the estimated volatility data in the day-to-day risk management process of the Authorised Person and if the Authorised Person is using a longer holding period for risk management compared to the ones prescribed in Rules A4.3.24 to A4.3.26., then the longer holding period must also be applied for the calculation of haircuts.
Guidance1. An Authorised Person should:a. take into account the illiquidity of lower quality Collateral and should adjust the holding period upwards in cases where such a holding period would be inappropriate given the liquidity of the Collateral; andb. identify where historical data may understate potential volatility (e.g. a pegged currency);and deal with such cases by subjecting the data to stress testing.2. An Authorised Person, when considering the market liquidity of a Collateral, should consider four dimensions:a. immediacy, which refers to the speed with which a trade of a given size at a given cost is completed;b. depth, which refers to the maximum size of a trade for any given bid-ask spread;c. tightness, which refers to the difference between buy and sell prices; andd. resiliency, which refers to how quickly prices revert to original or fundamental levels after a large transaction.3. The Authorised Person should have experienced Persons familiar with the relevant market for the Collateral to judge the market liquidity of the Collateral and determine if the minimum holding period is sufficient for any given Collateral. The holding period should be deemed to be insufficient if the value of the Collateral would move by more than 1% should the Collateral be liquidated within the minimum holding period in these Rules, taking into account the immediacy, depth, tightness and resiliency of the market. In such a situation, the holding period should be adjusted upwards, such that the Collateral can be safely liquidated within the period, without causing a price movement of more than 1% relative to the value after the haircut.4. An Authorised Person should aim to update its data sets daily in line with industry practice. If the Authorised Person updates its data sets less than once every three months, it should be able to demonstrate to the Regulator that the volatilities of the market prices are stable. In addition, where the updating of data sets is less frequent, the Regulator will normally expect compensating controls in the form of stress testing.
PRU A4.3.23 PRU A4.3.23
An Authorised Person must have robust and effective processes in place for ensuring compliance with documented internal policies, controls and procedures concerning the operation of the risk measurement system to support the use of own-estimate haircuts.
In order to demonstrate compliance with Rule A4.3.23, an Authorised Person should give due regard to the following expectations of the Regulator:(a) the risk measurement system should be used in conjunction with internal Exposure limits;(b) the risk management processes of an Authorised Person relating to the use of own-estimate haircuts should be subject to internal audit at least once a year, covering the following areas:(i) the integration of risk measures into daily risk management;(ii) the validation of any significant change in the risk management process;(iii) the accuracy and completeness of position data;(iv) the verification of the consistency, timeliness and reliability of data sources used to run internal models, including the independence of such data sources; and(v) the accuracy and appropriateness of volatility assumptions.(c) such internal audits referred to in (b) are not to be confused with an internal validation of the risk management systems surrounding the use of own-estimate haircuts. All significant risk models employed to support the use of own-estimate haircuts should be validated at least once a year. The internal audits serve as an independent process check to help ensure that the validation is sufficiently robust and effective.