On 17 December 2024, the European Banking Authority (EBA) issued a final report containing draft regulatory technical standards (RTS) on the conditions for determining whether an instrument attracting residual risk acts as a hedge.

Background

The draft RTS has been developed in accordance with Article 325(u)(6) of the Capital Requirements Regulation (CRR) (as amended by the CRR 3). Under this Article the EBA is mandated to specify the criteria to identify positions attracting residual risk that act as a hedge.

One of the pillars of the standardised approach / sensitivity-based method (SA/SbM) under the new fundamental review of the trading book (FRTB) framework is the residual risk add-on (RRAO).

Among other things the CRR 3 provides for exemptions from the RRAO charge for those hedging instruments bearing residual risks taken as a hedge for hedged instruments bearing residual risks too. The subject of the hedge is just the hedge, i.e. the hedged position must always be capitalised with an RRAO charge.

Draft RTS

The specific objective of the draft RTS is to establish common criteria of when an instrument bearing residual risk qualifies as a hedge for the purposes of the RRAO exemption. In this way, the draft RTS aim to ensure a consistent implementation of the RRAO across EU institutions.

The draft RTS distinguish between cases where the residual risk:

  1. Does not relate to an instrument that reference an exotic underlying and exclusively relates to a risk factor that is not shocked in the SbM (i.e. non-SbM risk factor). Simple constant maturity swap spread options are expected to fall under this case, given that they bear an additional correlation risk factor that is not shocked as part of the sensitivity-based method.
  2. Relates to an instrument that refers to an exotic underlying that is a dividend, a future realized volatility or variance. Simple variance swaps are expected to fall in this case.
  3. Relates to other reasons than the one stated in point a or b. For example, digital options or barrier options trigger the RRAO for their complex pay-off, or for the path dependent nature of the derivative.

Next steps

The final report notes that in accordance with Commission Delegated Regulation (EU) 2024/2795 postponing the FRTB by one year, institutions are required to use the CRR2 version of the FRTB requirements. The RRAO exemption framed by the draft RTS will be applicable only once CRR3 FRTB implementation comes into force.