PIB A5.1 Guidance
1. In accordance with PIB section 5.2, an
Authorised Firm is required to have a Market Risk policy. The Market Risk policy should address all aspects of Market Risk whether arising from assets, liabilities or the mismatch between assets and liabilities and whether off or on-balance sheet. Such a policy would be expected to include the following information:
a. how, with particular reference to its activities, the
Authorised Firm defines and measures Market Risk;
Authorised Firm's investment or trading strategy distinguishing, as applicable, between its Trading and Non-Trading Books;
c. the detailed limit structure for
Market Risk which should:
i. address all key risk factors;
ii. be commensurate with the volume and complexity of activity; and
iii. be consistent with the
Authorised Firm's strategy, historical performance, and the overall level of earnings or capital the Authorised Firm is willing to risk;
d. procedures for:
i. approving new products and activities that give rise to
ii. regular risk position and performance reporting;
iii. limit exception reporting and approval; and
iv. reporting and controlling of off-market trades, if these are permitted;
e. where internal models are used to set
Capital Requirements (as provided for in PIB section 5.3), the methods and assumptions used in these models and how the models are tested; and
f. the allocation of responsibilities for implementing the
Market Risk policy and for monitoring adherence to, and the effectiveness of, the policy.
Authorised Firm should measure its Market Risk using a robust and consistent methodology. The appropriate method of measurement will depend upon the nature of the products traded. The Authorised Firm should consider whether the measurement methodologies should be tested, for example, through back-testing, and the frequency of such testing.
Authorised Firm should be able to measure its Market Risk Exposure both across risk types, such as interest rate, foreign exchange and commodities, and across the entire portfolio.
4. Where an
Authorised Firm is a member of a Group, which is subject to consolidated supervision, the Group should be able to monitor Market Risk Exposures on a consolidated basis (PIB chapter 8).
Authorised Firm should have the capability to assess the impact of any new transaction on its Market Risk position on an on-going basis, and should be capable of carrying out a full measurement of its positions at least daily.
Authorised Firm should implement an effective system for monitoring its Market Risk. This system should be independent of those within the Authorised Firm who are responsible for taking Market Risk.
Authorised Firm should implement a system of management reporting which provides relevant, accurate, comprehensive, timely and reliable Market Risk reports to relevant functions within the Authorised Firm. These reports should:
a. alert senior management's attention to the size of
Exposures and the relationship between these Exposures and limits;
b. cover exceptions to the
Authorised Firm's Market Risk policy;
c. present the results from stress tests undertaken; and
d. analyse and explain any changes to the level and nature of
Market Risk and any remedial action proposed or taken.
Authorised Firm should have procedures, including stop-loss procedures, for taking appropriate action according to the information within the management reports.
Authorised Firm should ensure that there are controls and procedures for reporting any trades booked at off-market rates.
Authorised Firm should ensure that risk monitoring is subject to a periodic independent check. Models used to determine or interpolate specific Market Risk factors should be independently reviewed or otherwise validated.
11. Particular attention should be given to the monitoring of
Market Risk that does not conform to the usual Market Risk policy, or which exceeds predetermined Market Risk limits and criteria, but is sanctioned because of particular circumstances in accordance with the Authorised Firm's procedures. Unauthorised exceptions to policies, procedures and limits should be reported in a timely manner to the appropriate level of management along with any remedial action proposed or taken.
Market Risk limits should be periodically reviewed in order to check their suitability for current market conditions and the Authorised Firm's overall risk appetite.
Authorised Firm should use a model or some form of analytical tool to assess risk in complex instruments or across portfolios. An Authorised Firm which wishes to use such a model to determine part of its financial resources requirement, should refer to PIB section 5.3.
Authorised Firm should also use stress testing to determine the potential effects of economic downturns, market events, changes in interest rates, foreign exchange or liquidity conditions.
Authorised Firm should set an appropriate limit structure to control its Market Risk Exposure. The degree of granularity within the limit structure, or how hierarchical it is, will depend on the nature of the products traded (for example, whether the underlying risks are linear or non-linear) and the scale of the Authorised Firm's overall business (for example, whether the Authorised Firm is an active market maker). An Authorised Firm should set limits on risks such as simple price or rate risk as well as on the factors, Delta, Gamma, Vega, Rho, and Theta, arising from options positions.
16. Limits should also be imposed against net or gross positions, and in relation to maximum allowable loss ('stop-loss'), value at risk, maturity gap, and illiquid or volatile markets.
Authorised Firm should provide a process for the identification, timely reporting and subsequent action in respect of exceptions to limits. An Authorised Firm should also ensure that limit breaches and action arising from exceptions are monitored. An Authorised Firm may also consider whether it is appropriate to set intermediate thresholds that alert management when limits are approached, triggering review or other appropriate action, or both.
18. Various methods can be used to hedge
Market Risk. An Authorised Firm should document the appropriate products to be used to hedge Exposure and identify individuals within the Authorised Firm or Group responsible for monitoring hedge performance.
Authorised Firm should ensure that it makes and maintains appropriate prudential records which show and explain the Authorised Firm's transactions, disclose its financial position and Exposure to Market Risk and enable it to demonstrate compliance with the DFSA rules. In particular, an Authorised Firm should have data history to enable it to perform back-testing of methods and assumptions used for stress and scenario testing and for value-at-risk models. Market Risk records should be retained for at least six years.
Derived from RM111/2012 (Made 15th October 2012). [VER20/12-12]