MIFIDPRU 4.12 K-NPR requirement

1. (1)

   2Certain market risk provisions in the UK CRR (in the form in which it stood on 31 December 2021) require a firm to consider the underlying credit risk attaching to a position under the UK CRR Standardised Approach to credit risk. In certain cases, the credit risk rules require a firm to determine the risk attaching to the position by reference to “credit quality steps”, which are mapped to credit ratings issued by particular credit rating agencies. As the credit risk requirements in the UK CRR are no longer directly relevant under MIFIDPRU, the FCA will no longer be maintaining an FCA version of the ECAI credit quality step mappings in BTS 2016/1799 for these purposes.

2. (2)

   The effect of MIFIDPRU 4.12.2BR is that where a firm needs to determine the underlying credit risk of a position for the purposes of the K-NPR requirement by reference to credit quality steps, the firm should use the updated ECAI mappings maintained by the PRA for the purposes of the Standardised Approach to credit risk as it applies to CRR firms under the PRA Rulebook.

1 MIFIDPRU 4.12.8R to MIFIDPRU 4.12.65G contain rules and guidance setting out requirements for internal models and explaining the factors that the FCA will consider when deciding whether to grant permission to use an internal model.

1. (1)

   1The methodology for identifying the risks in MIFIDPRU 4.12.8R and calculating additional own funds for VaR and sVaR models is called the “Risks not in VaR (RNIV) framework”. A firm is responsible for identifying these additional risks and this should be an opportunity for risk managers and the firm’s management to better understand the shortcomings of the firm’s models. Following this initial assessment, the FCA will engage with the firm to provide challenge and ensure an appropriate outcome.

2. (2)

   The RNIV framework is intended to ensure that own funds are held to meet all risks that are not captured, or not captured adequately, by the firm’s VaR and sVaR models. These include, but are not limited to, missing and/or illiquid risk factors such as cross-risks, basis risks, higher-order risks, and calibration parameters. The RNIV framework is also intended to cover event risks that could adversely affect the relevant business.

3. (3)

   A firm should systematically identify and measure all risks that are not captured, or not captured adequately. This analysis should be carried out at least quarterly, but the FCA may request more frequent analysis. The measurement of these risks should capture the losses that could arise due to the risk factor(s) of all products that are within the scope of the permission for the relevant internal model, but are not adequately captured by the relevant internal model.

4. (4)

   On a quarterly basis, the firm should identify and assess individual risk factors covered by the RNIV framework. The FCA will review the results of this exercise and may require that firms identify additional risk factors as being eligible for measurement.

5. (5)
   1. (a)

      Where sufficient data is available, and where it is appropriate to do so, the FCA expects a firm to calculate a VaR and sVaR metric for each risk factor within scope of the framework. The stressed period for the RNIV framework should be consistent with that used for sVaR. No offsetting or diversification may be recognised across risk factors included in the RNIV framework. The multipliers used for VaR and sVaR should be applied to generate a K-NPR requirement.

   2. (b)

      If it is not appropriate to calculate a VaR and sVaR metric for a risk factor, a firm should instead measure the size of the risk based on a stress test. The confidence level and capital horizon of the stress test should be commensurate with the liquidity of the risk, and should be at least as conservative as comparable risk factors under the internal model approach. The capital charge should be at least equal to the losses arising from the stress test.

1If a MIFIDPRU investment firm has notified the FCA under MIFIDPRU 4.12.10R that a model meets the minimum standards for a particular option type, but is subsequently unable to demonstrate to the FCA that the model meets those minimum standards, the FCA may apply a capital add-on and agree a risk mitigation plan. If a firm does not comply with the risk mitigation plan within the mandated timeframe, the FCA may take further supervisory measures. This may include variation of a firm’s Part 4A permission so that the firm is no longer allowed to trade the relevant option types.

1The sophistication of a pricing model used to calculate own estimates of delta for use in the standardised approach for options should be proportionate to the complexity and risk of each option and the overall risk of the firm’s options trading business. In general, the FCA considers that the risk of sold options will be higher than the risk of the same options when bought.

1Delta should be recalculated at least daily. A firm should also recalculate delta promptly if there are significant movements in the market parameters used as inputs to calculate delta.

1The pricing model used to calculate delta should be:

1. (1)

   based on appropriate assumptions that have been assessed and challenged by suitably qualified parties independent of the development process;

2. (2)

   independently tested, including validation of the mathematics, assumptions and software implementation; and

3. (3)

   developed or approved independently of the trading desk.

1A firm should use generally accepted industry standard pricing models for the calculation of own deltas where these are available, such as for relatively simple options.

1The IT systems used to calculate delta should be sufficient to ensure delta is calculated accurately and reliably.

1A firm should have adequate systems and controls in place when using a pricing model to calculate delta. This should include the following documented policies and procedures:

1. (1)

   clearly defined responsibilities of the various areas involved in the calculation;

2. (2)

   frequency of independent testing of the accuracy of the model used to calculate delta; and

3. (3)

   guidelines for the use of unobservable inputs, where relevant.

1A firm should ensure its risk management functions are aware of weaknesses of the model used to calculate a delta. Where a firm identifies weaknesses, it should ensure that estimates of delta result in a prudent contribution to the K-NPR requirement. The outcome should be prudent across the whole portfolio of options and underlying positions at all times.

1For the purposes of article 327(2) of the UK CRR, the convertible should be:

1. (1)

   treated as a position in the equity into which it converts; and

2. (2)

   the component of the firm’s K-NPR requirement attributable to the general and specific risk in its equity instruments should be adjusted by making:

   1. (a)

      an addition equal to the current value of any loss that the firm would make if it did convert to equity; or

   2. (b)

      a deduction equal to the current value of any profit that the firm would make if it did convert to equity (subject to a maximum deduction equal to the K-NPR requirement that would be attributable to the notional position underlying the convertible).

1Article 331(2) of the UK CRR (Interest rate risk in derivative instruments) sets out conditions that must be met before a firm not using interest rate pre-processing models can fully offset interest rate risk on derivative instruments. One of the conditions is that the reference rate (for floating-rate positions) or coupon (for fixed-rate positions) should be ‘closely matched’. The FCA will normally consider a difference of less than 15 basis points as indicative of the reference rate or coupon being ‘closely matched’ for the purposes of this requirement. A firm that wishes to use sensitivity models to calculate interest rate risk on derivative instruments in accordance with article 331(1) of the UK CRR should refer to MIFIDPRU 4.12.66R.

1. (1)

   1The FCA’s starting assumption is that all overshootings should be taken into account to calculate addends. If a firm believes that an overshooting should not count for that purpose, it should seek a variation of its VaR model permission from the FCA in accordance with MIFIDPRU 4.12.4R to exclude the overshooting.

2. (2)

   An example of when a firm’s overshooting might properly be disregarded is when it has arisen as a result of a risk that is not captured in a firm’s VaR model but against which own funds are already held.

1 MIFIDPRU 4.12.24G to MIFIDPRU 4.12.38G set out guidance for the derivation of notional positions for standardised approaches to market risk under the UK CRR.

1Futures or forwards on a basket or index of debt securities should be converted into forwards on single debt securities as follows:

1. (1)

   futures or forwards on a single currency basket or index of debt securities should be treated as either:

   1. (a)

      a series of forwards, one for each of the constituent debt securities in the basket or index, of an amount that is a proportionate part of the total underlying the contract, according to the weighting of the relevant debt security in the basket; or

   2. (b)

      a single forward on a notional debt security; and

2. (2)

   futures or forwards on multiple currency baskets or indices of debt securities should be treated as either:

   1. (a)

      a series of forwards (using the method in (1)(a)); or

   2. (b)

      a series of forwards, each one on a notional debt security to represent one of the currencies in the basket or index, of an amount that is a proportionate part of the total underlying the contract according to the weighting of the relevant currency in the basket.

1Notional debt securities derived through this treatment should be assigned a specific risk position risk adjustment and a general market risk position risk adjustment equal to the highest that would apply to the debt securities in the basket or index.

1The debt security with the highest specific risk position risk adjustment within the basket might not be the same as the one with the highest general market risk position risk adjustment. A firm should select the highest percentages, even if they relate to different debt securities in the basket or index, and regardless of the proportion of those debt securities in the basket or index.

1Where a debt security pays coupons in one currency but will be redeemed in a different currency, it should be treated as:

1. (1)

   a debt security denominated in the coupon’s currency; and

2. (2)

   a foreign currency forward to capture the fact that the debt security’s principal will be repaid in a different currency from that in which it pays coupons, specifically:

   1. (a)

      a notional forward sale of the coupon currency and purchase of the redemption currency, in the case of a long position in the debt security; or

   2. (b)

      a notional forward purchase of the coupon currency and sale of the redemption currency, in the case of a short position in the debt security.

1Other futures, forwards, and swaps for which a treatment is not specified in article 328 of the UK CRR (Interest rate futures and forwards) should be treated as positions in zero specific risk securities, each of which:

1. (1)

   has a zero coupon;

2. (2)

   has a maturity equal to that of the relevant contract; and

3. (3)

   is long or short, as set out in the table in MIFIDPRU 4.12.29G.

1Interest rate swaps or foreign currency swaps with a deferred start should be treated as two notional positions (one long, one short). The paying leg should be treated as a short position in a zero specific risk security with a coupon equal to the fixed rate of the swap. The receiving leg should be treated as a long position in a zero specific risk security that also has a coupon equal to the fixed rate of the swap.

1The maturities of the notional positions in MIFIDPRU 4.12.30G are set out in the table in MIFIDPRU 4.12.32G.

1For interest rate risk, a firm should treat a swap (such as an equity swap) with only one interest rate leg as a notional position in a zero specific risk security:

1. (1)

   with a coupon equal to that on the interest rate leg;

2. (2)

   with a maturity equal to the date that the interest rate will be reset; and

3. (3)

   that is a long position if the firm is receiving interest payments and is a short position if making interest payments.

1. (1)

   1A firm should treat a foreign currency forward, future or contract for differences as two notional currency positions as follows:

   1. (a)

      a long notional position in the currency that the firm has contracted to buy; and

   2. (b)

      a short notional position in the currency that the firm has contracted to sell.

2. (2)

   In (1), the notional positions should have a value equal to either:

   1. (a)

      the contracted amount of each currency to be exchanged in a forward, future or contract for differences held outside the trading book; or

   2. (b)

      the present value of the amount of each currency to be exchanged in a forward, future or contract for differences held in the trading book.

1. (1)

   1A firm should treat a foreign currency swap as:

   1. (a)

      a long notional position in the currency in which the firm has contracted to receive interest and principal; and

   2. (b)

      a short notional position in the currency in which the firm has contracted to pay interest and principal.

2. (2)

   In (1), the notional positions should have a value equal to either:

   1. (a)

      the nominal amount of each currency underlying the swap if it is held outside the trading book; or

   2. (b)

      the present value amount of all cash flows in the relevant currency in the case of a swap held in the trading book.

1Where a forward, future or contract for differences settles according to:

1. (1)

   the difference between the price set on trade date and the price prevailing at contract expiry, the notional position should:

   1. (a)

      equal the total quantity underlying the contract; and

   2. (b)

      have a maturity equal to the expiry date of the contract;

2. (2)

   the difference between the price set on trade date and the average of prices prevailing over a certain period up to contract expiry, a notional position should be derived for each of the reference dates used in the averaging period to calculate the average price, which:

   1. (a)

      equals a fractional share of the total quantity underlying the contract; and

   2. (b)

      has a maturity equal to the relevant reference date.

1Commitments to buy or sell at the average spot price of the commodity prevailing over some period between trade date and maturity should be treated as a combination of:

1. (1)

   a position equal to the full amount underlying the contract with a maturity equal to the maturity date of the contract, which should be:

   1. (a)

      long, where the firm will buy at the average price; or

   2. (b)

      short, where the firm will sell at the average price; and

2. (2)

   a series of notional positions, one for each of the reference dates where the contract price remains unfixed, each of which should:

   1. (a)

      be long if the position under (1) is short, or short if the position under (1) is long;

   2. (b)

      be equal to a fractional share of the total quantity underlying the contract; and

   3. (c)

      have a maturity date of the relevant reference date.

1The forward cash leg of a repurchase agreement or reverse repurchase agreement should be treated as a notional position in a zero specific risk security that:

1. (1)

   is a short notional position in the case of a repurchase agreement and a long notional position in the case of a reverse repurchase agreement;

2. (2)

   has a value equal to the market value of the borrowing or deposit;

3. (3)

   has a maturity equal to that of the borrowing or deposit, or the next date the interest rate is reset (if earlier); and

4. (4)

   has a coupon equal to:

   1. (a)

      zero, if the next interest payment date coincides with the maturity date; or

   2. (b)

      the interest rate on the borrowing or deposit, if any interest is due to be paid before the maturity date.

1 MIFIDPRU 4.12.40G to MIFIDPRU 4.12.65G describe some of the standards that the FCA expects to be met when it is considering an application under MIFIDPRU 4.12.4R to use an internal model.

1A firm should be able to demonstrate that it meets the risk management standards in article 368 of the UK CRR (Qualitative requirements) on a legal entity and business-line basis where appropriate. This is particularly important for a subsidiary in a group subject to matrix management where the business lines cut across legal entity boundaries.

1A VaR model permission generally sets out the broad classes of position within each risk category in its scope. It may also specify how individual products within one of the classes may be brought into or taken out of the scope of the VaR model permission. The broad classes of permission are:

1. (1)

   linear products, which comprise securities with linear pay-offs (such as bonds and equities) and derivative products which have linear pay-offs in the underlying risk factor (such as interest rate swaps, FRAs, and total return swaps);

2. (2)

   European, American and Bermudan put and call options (including caps, floors, and swaptions) and investments with these features;

3. (3)

   Asian options, digital options, single barrier options, double barrier options, look-back options, forward-starting options, compound options and investments with these features; and

4. (4)

   all other option-based products (such as basket options, quantos, outperformance options, timing options, and correlation-based products) and investments with these features.

1A firm should ensure that the data series used by its VaR model is reliable. Where a reliable data series is not available, the firm may use proxies or any other reasonable value-at-risk measurement if the model meets the requirements in article 367(2)(e) of the UK CRR (Requirements on risk measurement). The technique must be appropriate and must not materially understate the modelled risks.

1Data may be insufficient if, for example, it contains missing data points or data points that contain stale data. For less liquid risk factors or positions, the FCA expects the firm to make a conservative assessment of those risks, using a combination of prudent valuation techniques and alternative VaR estimation techniques to ensure there is a sufficient cushion against risk over the close-out period, which takes account of the illiquidity of the risk factor or position.

1A firm is expected to update data sets to maintain standards of reliability in accordance with the frequency set out in its VaR model permission, or more frequently if necessary due to volatility in market prices or rates. This is in order to ensure a prudent calculation of the VaR measure.

1. (1)

   1In determining whether it is appropriate for a firm to use empirical correlations within risk categories and across risk categories within a model, the FCA will consider whether such an approach is sound and implemented with integrity. In general, the FCA expects a firm to determine the aggregate VaR measure by adding the relevant VaR measure for each category, unless the firm’s permission provides for a different method of aggregating VaR measures that is empirically sound.

2. (2)

   The FCA does not expect a firm to use the square root of the sum of the squares approach when aggregating measures across risk categories unless the assumption of zero correlation between these categories is empirically justified. If correlations between risk categories are not empirically justified, the VaR measures for each category should simply be added to determine its aggregate VaR measure. However, to the extent that a firm’s VaR model permission provides for a different way of aggregating VaR measures:

   1. (a)

      that method applies instead; and

   2. (b)

      if the correlations between risk categories used for that purpose cease to be empirically justified then the firm is expected to notify the FCA immediately.

1A firm should demonstrate its ability to comply with the requirements for a VaR model permission. In general, a firm should have a back-testing programme in place and should provide 3 months of back-testing history.

1A firm should carry out a period of initial monitoring or live testing before the FCA will recognise a VaR model. This will be agreed on a firm-by-firm basis.

1The FCA will take into account the results of internal model validation procedures used by the firm to assess the VaR model when assessing the firm’s VaR model and risk management.

1 MIFIDPRU 4.12.50G to MIFIDPRU 4.12.53G provide further guidance on how a firm should comply with the requirements in article 366 of the UK CRR (Regulatory back testing and multiplication factors).

1If the day on which a loss is made is day n, the value-at-risk measure for that day will be calculated on day n-1, or overnight between day n-1 and day n. Profit and loss figures are produced on day n+1, and back-testing also takes place on day n+1. The firm’s supervisor should be notified of any overshootings by close of business on day n+2.

1Any overshooting initially counts for the purpose of the calculation of the plus factor, even if subsequently the FCA agrees to exclude it. Therefore, where the firm experiences an overshooting and already has 4 or more overshootings during the previous 250 business days, changes to the multiplication factor resulting from changes to the plus factor become effective at day n+3.

1A longer time period generally improves the power of back-testing. However, a longer time period may not be desirable if the VaR model or market conditions have changed to the extent that historical data is no longer relevant.

1The FCA will review a firm’s processes and documentation relating to the derivation of profit and loss used for back-testing when assessing a VaR model permission application under MIFIDPRU 4.12.4R. A firm’s documentation should clearly set out the basis for cleaning profit and loss. To the extent that certain profit and loss elements are not updated every day (for example, certain reserve calculations), the documentation should clearly set out how such elements are included in the profit and loss series.

1Under MIFIDPRU 4.12.6R, a firm must provide the FCA with details of any significant planned changes to the VaR model before those changes are implemented. This must include detailed information about the nature of the change, including an estimate of the impact on VaR numbers and the incremental risk charge. Material changes to internal models or material extensions to the use of internal models will require prior approval from the FCA.

1The use of overlapping intervals of 10-day holding periods for article 365 of the UK CRR (VaR and sVaR calculation) introduces an autocorrelation into the data that would not exist should truly independent 10-day periods be used. This may give rise to an under-estimation of the volatility and the VaR at the 99% confidence level. To obtain clarity on the materiality of the bias, a firm should measure the bias arising from the use of overlapping intervals for 10-day VaR and sVaR when compared to using independent intervals. A report on the analysis, including a proposal for a multiplier on VaR and sVaR to adjust for the bias, should be submitted to the FCA for review and approval.

1Under article 365 of the UK CRR (VaR and sVaR calculation), a firm that uses an internal model for calculating its K-NPR requirement must calculate, at least weekly, a sVaR of their current portfolio. The FCA would expect a sVaR internal model to contain the features in MIFIDPRU 4.12.57G to MIFIDPRU 4.12.60G before the FCA will grant permission to use the relevant model.

1A firm should calculate the sVaR measure to be greater than or equal to the average of the second and third worst loss in a 12-month time series comprising of 250 observations. The FCA expects, as a minimum, that a corresponding linear weighting scheme should be applied if the firm uses a larger number of observations.

1A firm should ensure that the sVaR period chosen is equivalent to the period that would maximise VaR, given the firm’s portfolio. A stressed period should be identified at each legal entity level at which capital is reported. Therefore, group level sVaR measures should be based on a period that maximises the group level VaR, whereas entity level sVaR should be based on a period that maximises VaR for that entity.

1The firm should consider whether the use of antithetic data in the calculation of the sVaR measure is appropriate to the firm’s portfolio. The firm should provide a justification to the FCA for using or not using antithetic data as part of an application to use an internal model.

1In its application to use an internal model, the firm should explain the reasons for the choice of absolute or relative shifts for both VaR and sVaR methodologies. In particular, the firm should evidence the statistical processes driving the risk factor changes for both VaR and sVaR.

1Under article 372 of the UK CRR (Requirement to have an internal IRC model), a firm that uses an internal model for calculating own funds requirements for specific risk of traded debt instruments must also have an internal incremental default and migration risk (IRC) model in place to capture the default and migration risk of its trading book positions that are incremental to the risks captured by its VaR model. When the FCA considers a firm’s application for permission to use an IRC internal model under MIFIDPRU 4.12.4R, it expects that the matters in MIFIDPRU 4.12.63G to MIFIDPRU 4.12.65G will be included to demonstrate compliance with the standards in article 372.

1The FCA expects the IRC model to capitalise pre-default basis risk. In this respect, the model should reflect that in periods of stress the basis could widen substantially. The firm should disclose to the FCA its material basis risks that are incremental to those already captured in existing market risk capital measures (VaR-based and others). This must take into account actual close-out periods during periods of illiquidity.

1The price/spread change model used to capture the profit and loss impact of migration should calibrate spread changes to long-term averages of differences between spreads for relevant ratings. These should either be conditioned on actual rating events, or use the entire history of spreads regardless of migration. Point-in-time estimates are not acceptable, unless the firm can demonstrate that they are as conservative as long-term averages.

1To achieve a soundness standard comparable to those under the Internal Ratings Based (IRB) approach, loss given default (LGD) estimates should reflect the economic cycle. Therefore, the FCA expects a firm to incorporate dependence of the recovery rate on the economic cycle into the IRC model. If the firm uses a conservative parameterisation to comply with the IRB standard of the use of downturn estimates, the firm should submit evidence of this in its quarterly reporting to the FCA. A firm should note that for trading portfolios that contain long and short positions, downturn estimates will not be a conservative choice in all cases.