Trading Book

Definition

A trading book in the context of financial regulation consists of financial instruments or positions in foreign exchange and commodities that are held for one or more of the following purposes:

• short-term resale;
• profiting from short-term price movements;
• locking in arbitrage profits;
• hedging risks that arise from instruments meeting the above criteria

Capital Requirements for Market Risk

Regulated financial services firms that have material trading books are subject to minimum capital requirements for Market Risk

The bulk of the capital required aims to cover the potential of losses associated with the key market risk factors:

• Delta Risk
• Vega Risk
• Curvature Risk

Additional capital provisions are required for so called Residual Risks (see below)

Issues and Challenges

The Trading Book / Banking Book Boundary

Certain types of financial instruments, most notably related to credit (e.g., loans) have been accounted for by banks under accrual accounting but can under certain conditions be held as traded positions in which case they are to be accounted for as FVPL fair value through PnL. This dual nature gives rise to ambiguity as to what are the applicable capital requirements, opening up possibilities for potential Regulatory Arbitrage, that is, using the classification that would require the least capital, irrespective of the true amount of risk.

Residual Risks

Besides the main types of market risk, a trading book may be exposed to a variety of other risk types which for typical portfolios may be less prominent. Examples are

• Gap Risk
• Correlation Risk
• Behavioural Risk
• Smile Risk
• Dividend Risk

Issues and Challenges

• A common feature of residual risks is that due to their nature, they may be harder to quantify and risk manage