The EBA publishes final draft technical standards on the conditions for determining whether an instrument attracting residual risk acts as a hedge

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 background

The 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.