Requirements for Use of Own-Estimate Haircuts
Authorised Firmusing own-estimate haircuts must estimate the volatility for each individual instrument that is taken as eligible financial Collateral. In estimating such volatility, the Authorised Firmmust not take into account the correlations between unsecured Exposures, Collateraland exchange rates. Where there are maturity mismatches, the Authorised Firmmust apply Rules PIB 4.13.14 to PIB 4.13.16.
Authorised Firmmust ensure that the model used to estimate volatilities captures all the material risks run by it.
PIB A4.3.22 PIB A4.3.22
In calculating the haircuts using internal estimates of volatilities, an
Authorised Firmmust:(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 PIB A4.3.24 to PIB A4.3.26. Where the minimum holding period, remargining or revaluation conditions used by an Authorised Firmdiffer from those set out above, it must adjust the haircuts using the formulae in Rules PIB A4.3.25 to PIB A4.3.26;(c) use a historical observation period (i.e. sample period) of at least one year. Where the Authorised Firmuses 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 DFSAmay 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 Firmand if the Authorised Firmis using a longer holding period for risk management compared to the ones prescribed in Rules PIB A4.3.24 to PIB A4.3.26., then the longer holding period must also be applied for the calculation of haircuts.
PIB A4.3.22 Guidance1. An
Authorised Firmshould:a. take into account the illiquidity of lower quality Collateraland 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 Firm, 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 Firmshould have experienced persons familiar with the relevant market for the Collateralto judge the market liquidity of the Collateraland 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 Collateralwould move by more than 1% should the Collateralbe 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 Collateralcan 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 Firmshould aim to update its data sets daily in line with industry practice. If the Authorised Firmupdates its data sets less than once every three months, it should be able to demonstrate to the DFSAthat the volatilities of the market prices are stable. In addition, where the updating of data sets is less frequent, the DFSAwill normally expect compensating controls in the form of stress testing.
PIB A4.3.23 PIB A4.3.23
Authorised Firmmust 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.
PIB A4.3.23 Guidance
In order to demonstrate compliance with PIB Rule A4.3.23, an
Authorised Firmshould give due regard to the following expectations of the DFSA:(a) the risk measurement system should be used in conjunction with internal Exposurelimits;(b) the risk management processes of an Authorised Firmrelating 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.