In the first blog post from The
Flipper our new anonymous non de plume open to all across the
industry to write under the cloak of anonymity, we look at
the impact of CRD IV's capital requirements rules on the prop
Much is known about the challenges that
banks are facing in complying with the capital requirements set
out under CRD IV. However, less well understood is the
potentially devastating impact on market markers and
proprietary trading firms.
CRD IV and the associated regulation CRR
are aimed at:
(a) minimising the negative effects of
firms failing by ensuring that firms hold enough financial
resources to cover the risk associated with their
(b) increasing the likelihood that a
firms' personnel take an interest in the longer-term success of
the business rather than short-term gains (for which read
Most proprietary trading firms, which are
Part 4 FSMA authorised by the FCA, are affected.
There are a number of
'simple’ rules which apply to remuneration of
certain employees, however, much more contentious are the rules
which deal with firms’ capital adequacy.
The rules provide standard models for
firms to calculate their capital adequacy requirements, the
upshot of which is that for futures (where the capital
requirements can be spectacular) firms must set aside Pillar 1
position risk capital of an order of magnitude related to the
notional value of the derivative’s underlying
To be clear, for short-end sterling
interest rate futures the notional value is
Inserting this multiplier into the
standard position risk calculations (CRR 326 onwards and
particularly CRR 339) is tantamount to basing regulatory
capital requirements off the risk of a total loss; ie. that the
future goes to zero.
Admittedly the spectacular position risk
figures generated are subject to various haircuts as firms
determine their own funds requirements (e.g. CRR
But still, a simple exchange traded and
highly liquid fixed income or interest rate future requires
regulatory capital orders of magnitude larger than any firm or
exchange risk model would predict or clearer would require as
In short, firms may potentially face
a catastrophic capital adequacy hit, especially when trading
futures at the short end of the curve.
Options are treated similarly to futures
although the amount of the capital required to cover an option
will depend on its delta.
Equities receive a more favourable
treatment - the concept of notional value is of course not
pertinent to equities so the regulators have taken a different
approach that produces significantly lower capital adequacy
In contrast to the standardised approach,
firms might try to follow the banks by running their own risk
models to determine Pillar 1 position risk
However, agreeing a bespoke risk model
with the FCA could take months, if not a year, and in the
meantime firms would need to apply the standard model.
The good news is that even if a firm uses
the standard model, there are a number of ways in the model
pursuant to which firms can apply haircuts and netting to
reduce their capital adequacy requirements. The bad news is it
does not reduce the amounts substantially.
The other good news is that the FCA does
seem currently open to considering applying different
methodologies and calculations, although the timetable for (and
results of) that are uncertain.
What the FCA has been spending more time
doing of late is complaining that the Dutch have permitted
firms which the AFM regulates to apply different models which
lead to those firms having substantially lower capital adequacy
requirements (and therefore a significant commercial
According to various people, the AFM has
(a) it will not permit any firms not
currently authorised and regulated by it to come to the
(b) it will move to the standard model
some time in the next couple of years (probably on the same
timetable as MiFID2 implementation).
So all EU firms will be in the same boat
eventually, although this isn’t really a
Some argue (and with good reason) that
proprietary trading firms (which generally have good pre- and
post-trade systems and controls and internal risk management
and substantial margin and net liq requirements) do not present
a systemic risk of anything like the magnitude that should
require them to hold capital of such enormous
firms may potentially face a catastrophic capital adequacy hit, especially when trading futures at the short end of the curve.
This could (and will) drive some players
out of the market, leading to lower liquidity, wider spreads
Those firms which have been around (or
have been subject to Pillar 1 CRR position risk requirements)
for some time may well have long-standing internal risk models
which have been agreed with the FCA.
Those firms which became Part 4 FSMA
authorised because of the German HFT law or which are planning
to become authorised and regulated under MiFID2 do not have
Counter-intuitively, also, since banks
most likely have long-established internal risk models, even
though they are much more likely to be the target of CRD IV and
CRR, they will find themselves less affected than smaller
proprietary trading firms.
"Bad things will
So let’s assume that a firm
needs to calculate its capital adequacy requirements; how does
it do so?
Well, it can build its own calculator
(some firms have) or it can 'buy’ one from a
vendor. Beware, however, that one vendor’s
application of the model to a calculator might differ from
another’s, giving (perhaps wildly) different
If the FCA does not agree with a
firm’s calculations, bad things will
Is it any defence for a firm to say that
it used a trusted and well-known vendor’s
calculator? Maybe but probably not - it’s a lack
of control over the quality of external providers.
So should a firm build its own calculator?
That would depend on costs, I suppose - because if a
firm’s own calculator 'gets it wrong’
it’s the firm which is firmly on the hook for
So where next? Let’s hope
that the FCA looks at the different models out there and the
ways in which the industry reduces the probability of a firm
blowing up and/or a firm blowing up and taking the market with
There may be some advantages in firms that
will need to become authorised and regulated under MiFID2
waiting-and-seeing. However, the smart (maybe not
'smart’ - the 'cynical’) money is on
the FCA not agreeing to a firm applying an internal risk model
without it having run standard models for some time first or
having a track-record of applying successfully an internal risk
So for firms that are contemplating
becoming authorised and regulated under MiFID2, perhaps the
best thing to do is to set up asap and run an unregulated
business for a period of time to gather data to show the FCA
(when an application is presented to it) that show the
firm’s own risk model 'works’.