Does the requirement to obtain competent authorities’ permission for delta models (Articles 329(1), 352(1), 358(3) of the CRR) for the purposes of market risk capital requirements apply also to back-to-back positions?
By ‘back-to-back positions’ we refer to a case where any position in an option on a certain underlying is immediately closed by an offsetting trade in the same option on the same underlying.
Pursuant to the abovementioned articles, for the purposes of own funds requirements for market risk, positions in options shall be included on the basis of their delta equivalent. For OTC options, the CRR states that ‘the institution may calculate delta itself using an appropriate model, subject to permission by the competent authorities’. The CRR doesn’t explicitly resolve whether the requirement to obtain competent authorities’ permission applies to positions that are perfectly matching (i.e. back-to-back), therefore generating no market risk for the institution.
In such a case, the delta equivalent of the long and short positions in a given underlying will be offset, thus generating no open position. This means that for a business model which allows only back-to-back positions in certain options, regardless of the model used, the net position will always be zero. In fact, in order to calculate the own funds requirement for market risk, no model needs to be used for back-to-back positions (i.e. one can determine the net position as zero without using any model whatsoever), which renders the competent authorities’ approval redundant.
In the case of back-to-back booking, i.e. when all positions are perfectly matching (both transactions have opposite risk positions and all their other features are identical), there is no open position for the institution. Therefore, it does not bear market risk for those transactions.
On this ground, it is not necessary to go through the process of model approval for delta, since it aims at capturing a risk that is not present in the case referred to here. Therefore, an institution needs no permission to use own delta estimates if it is capable to prove that the positions are perfectly matching.
See also Q&A 2016_2571.
Update 26.03.2021: This Q&A has been reviewed in the light of the changes introduced to Regulation (EU) No 575/2013 (CRR) and continues to be relevant.