II BOUNDARY BETWEEN BOOKS
7 Scope of the Trading Book
23 A trading book consists of all instruments that meet the specifications for trading book instruments set out in paragraphs 24 to 35. All other instruments should be included in the banking book.
24 Instruments comprise financial instruments, foreign exchange (FX), and commodities.
A financial instrument is any contract that gives rise to both a financial asset of one entity and a financial liability or equity instrument of another entity. Financial instruments include both primary financial instruments (or cash instruments) and derivative financial instruments. A financial asset is any asset that is cash, the right to receive cash or another financial asset or a commodity, or an equity instrument. A financial liability is the contractual obligation to deliver cash or another financial asset or a commodity. Commodities also include non-tangible (i.e. non-physical) goods such as electric power.
25 An AI should only include a financial instrument, instruments on FX or commodity in the trading book when there is no legal impediment against selling or fully hedging it.
26 An AI should fair value daily any trading book instrument and recognise any valuation change in the profit and loss (P&L) account.
7.1 Standards for Assigning Instruments to the Regulatory Books
27 When an AI holds any instrument for one or more of the following purposes, the AI should designate it as a trading book instrument upon initial recognition on its books, unless specifically otherwise provided for in paragraph 25 or paragraph 30:
short-term resale;
profiting from short-term price movements;
locking in arbitrage profits; or
hedging risks that arise from instruments meeting the criteria above.
28 Any of the following instruments is seen as being held for at least one of the purposes listed in paragraph 27 and should therefore be included in the trading book, unless specifically otherwise provided for in paragraph 25 or paragraph 30:
instruments in the correlation trading portfolio;4
instruments that would give rise to a net short credit or equity position in the banking book;5 or
instruments resulting from underwriting commitments, where underwriting commitments refer only to securities underwriting, and relate only to securities that are expected to be actually purchased by an AI on the settlement date.
29 Any instrument which is not held for any of the purposes listed in paragraph 27 at inception, nor seen as being held for these purposes according to paragraph 28, should be assigned to the banking book.
30 An AI should assign the following instruments to the banking book:
unlisted equities;
instruments designated for securitisation warehousing;
real estate holdings, where in the context of assigning instrument to the trading book, real estate holdings relate only to direct holdings of real estate as well as derivatives on direct holdings;
retail and small or medium-sized enterprise (SME) credit;
equity investments in a fund, unless the AI meets at least one of the following conditions:
– the AI is able to look through the fund to its individual components and there is sufficient and frequent information, verified by an independent third party, provided to the AI regarding the fund’s composition; or
– the AI obtains daily price quotes for the fund and it has access to the information contained in the fund’s mandate or in the national regulations governing such investment funds;
hedge funds;
derivative instruments and funds that have the above instrument types as underlying assets; or
instruments held for the purpose of hedging a particular risk of a position in the types of instrument above.
31 There is a general presumption that any of the following instruments are being held for at least one of the purposes listed in paragraph 27 and therefore are trading book instruments, unless specifically otherwise provided for in paragraph 25 or paragraph 30:
4 The term “correlation trading portfolio” has the same meaning as defined in section 281 of the BCR.
5 An AI will have a net short risk position for equity risk or credit risk in the banking book if the present value of the banking book increases when an equity price decreases or when a credit spread on an issuer or group of issuers of debt increases.
instruments held as accounting trading assets or liabilities;6
instruments resulting from market-making activities;
equity investments in a fund excluding those assigned to the banking book in accordance with paragraph 30;
listed equities;7
trading-related repo-style transaction;8 or
options including embedded derivatives9 from instruments that the institution issued out of its own banking book and that relate to credit or equity risk.
32 An AI is allowed to deviate from the presumptive list specified in paragraph 31 according to the process set out below.
If an AI believes that it needs to deviate from the presumptive list established in paragraph 31 for an instrument, it should submit a request to the HKMA and receive explicit approval. In its request, the AI should provide evidence that the instrument is not held for any of the purposes in paragraph 27.
In cases where this approval is not given by the HKMA, an AI should designate the instrument as a trading book instrument. The AI should document any deviations from the presumptive list in detail on an ongoing basis.
7.2 Supervisory Powers
6 Under HKAS 39, these instruments would be designated as held for trading. Under HKFRS 9, these instruments would be held within a trading business model. These instruments would be fair valued through the P&L account.
7 Subject to the HKMA’s review, certain listed equities may be excluded from the market risk framework. Examples of equities that may be excluded include, but are not limited to, equity positions arising from deferred compensation plans, convertible debt securities, loan products with interest paid in the form of “equity kickers”, equities taken as a debt previously contracted, bank-owned life insurance products, and legislated programmes. The set of listed equities that an AI wishes to exclude from the market risk framework should be made available to, and discussed with, the HKMA and should be managed by a desk that is separate from desks for proprietary or short-term buy/sell instruments.
8 Repo-style transactions that are (i) entered for liquidity management and (ii) valued at accrual for accounting purposes are not part of the presumptive list of paragraph 31.
9 An embedded derivative is a component of a hybrid contract that includes a non-derivative host such as liabilities issued out of an AI’s own banking book that contain embedded derivatives. The embedded derivative associated with the issued instrument (i.e. host) should be bifurcated and separately recognised on the AI’s balance sheet for accounting purposes.
banking book, the HKMA may require the AI to assign the instrument to the banking book, except if it is an instrument listed under paragraph 28.
34 The HKMA may require an AI to provide evidence that an instrument in the banking book is not held for any of the purposes of paragraph 27. If the HKMA is of the view that the AI has not provided enough evidence, or if the HKMA believes such instruments would customarily belong in the trading book, the HKMA may require the AI to assign the instrument to the trading book, except if it is an instrument listed under paragraph 30.
7.3 Documentation of Instrument Designation
35 An AI should have clearly defined policies, procedures and documented practices for determining which instruments to include in or to exclude from the trading book for the purposes of calculating their regulatory capital, ensuring compliance with the criteria set forth in this subsection, and taking into account an AI’s risk management capabilities and practices. The AI’s internal control functions should conduct an ongoing evaluation of instruments both in and out of the trading book to assess whether its instruments are being properly designated initially as trading or non-trading instruments in the context of the AI’s trading activities. Compliance with the policies and procedures should be fully documented and subject to periodic (at least yearly) internal audit and the results should be available for the HKMA to review.
7.4 Restrictions on Moving Instruments between the Regulatory Books
36 Apart from moves required by subsection 7.1, there is a strict limit on the ability of an AI to move instruments between the trading book and the banking book by their own discretion after initial designation, which is subject to the process in paragraphs 37 and 38. Switching instruments for regulatory arbitrage is strictly prohibited. In practice, switching should be rare and will be allowed by the HKMA only in extraordinary circumstances. Examples are a major publicly announced event, such as an AI restructuring that results in the permanent closure of trading desks, requiring termination of the business activity applicable to the instrument or portfolio or a change in accounting standards that allows an item to be fair-valued through P&L. Market events, changes in the liquidity of a financial instrument, or a change of trading intent alone are not valid reasons for reassigning an instrument to a different book. When switching positions, the AI should ensure that the standards described in subsection 7.1 are always strictly observed.
37 Without exception, a capital benefit as a result of switching will not be allowed in any case or circumstance. This means that an AI should determine its total capital charge (across the banking book and trading book) before and immediately after the switch. If this capital charge is reduced as a result of this switch, the difference as measured at the time of the switch will be imposed on the AI as a disclosed Pillar 1 capital surcharge. This surcharge will be allowed to run off as the positions mature or expire, in a manner agreed with the HKMA. To maintain operational simplicity, it is not envisaged that this additional capital charge would be recalculated on an ongoing basis, although the positions would continue to also be subject to the ongoing capital charges of the book into which they have been switched.
38 Any reassignment between books should be approved by senior management and the HKMA as follows. Any reallocation of securities between the trading book and banking book, including outright sales at arm’s length, should be considered a reassignment of securities and is governed by requirements of this paragraph.
Any reassignment should be approved by senior management; thoroughly documented; determined by internal review to be in compliance with an AI’s policies; subject to prior approval by the HKMA based on supporting documentation provided by the AI; and publicly disclosed.
Unless required by changes in the characteristics of a position, any such reassignment is irrevocable.
If an instrument is reclassified to be an accounting trading asset or liability there is a presumption that this instrument is in the trading book, as described in paragraph 31. Accordingly, in this case an automatic switch without approval of the HKMA is acceptable.
39 An AI should adopt relevant policies that are updated at least yearly. Updates should be based on an analysis of all extraordinary events identified during the previous year. Updated policies with changes highlighted should be sent to the HKMA. Policies should include the following:
The reassignment restriction requirements in paragraphs 36 to 38, especially the restriction that re-designation between the trading book and banking book may only be allowed in extraordinary circumstances, and a description of the circumstances or criteria where such a switch may be considered.
The process for obtaining senior management and supervisory approval for such a transfer.
How the AI identifies an extraordinary event.
A requirement that re-assignments into or out of the trading book be publicly disclosed at the earliest reporting date.