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Directive 2006/49/EC of the European Parliament and of the Council of 14 June 2006 on the capital adequacy of investment firms and credit institutions (recast) (repealed)
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This is the original version (as it was originally adopted).
there must be a clearly documented trading strategy for the position/instrument or portfolios, approved by senior management, which shall include expected holding horizon;
there must be clearly defined policies and procedures for the active management of the position, which shall include the following:
positions entered into on a trading desk;
position limits are set and monitored for appropriateness;
dealers have the autonomy to enter into/manage the position within agreed limits and according to the approved strategy;
positions are reported to senior management as an integral part of the institution's risk management process; and
positions are actively monitored with reference to market information sources and an assessment made of the marketability or hedge‐ability of the position or its component risks, including the assessment of, the quality and availability of market inputs to the valuation process, level of market turnover, sizes of positions traded in the market; and
there must be clearly defined policy and procedures to monitor the position against the institution's trading strategy including the monitoring of turnover and stale positions in the institution's trading book.
documented policies and procedures for the process of valuation. This includes clearly defined responsibilities of the various areas involved in the determination of the valuation, sources of market information and review of their appropriateness, frequency of independent valuation, timing of closing prices, procedures for adjusting valuations, month end and ad‐hoc verification procedures; and
reporting lines for the department accountable for the valuation process that are clear and independent of the front office.
The reporting line shall ultimately be to a main board executive director.
senior management shall be aware of the elements of the trading book which are subject to mark to model and shall understand the materiality of the uncertainty this creates in the reporting of the risk/performance of the business;
market inputs shall be sourced, where possible, in line with market prices, and the appropriateness of the market inputs of the particular position being valued and the parameters of the model shall be assessed on a frequent basis;
where available, valuation methodologies which are accepted market practice for particular financial instruments or commodities shall be used;
where the model is developed by the institution itself, it shall be based on appropriate assumptions, which have been assessed and challenged by suitably qualified parties independent of the development process;
there shall be formal change control procedures in place and a secure copy of the model shall be held and periodically used to check valuations;
risk management shall be aware of the weaknesses of the models used and how best to reflect those in the valuation output; and
the model shall be subject to periodic review to determine the accuracy of its performance (e.g. assessing the continued appropriateness of assumptions, analysis of profit and loss versus risk factors, comparison of actual close out values to model outputs).
For the purposes of point (d), the model shall be developed or approved independently of the front office and shall be independently tested, including validation of the mathematics, assumptions and software implementation.
internal hedges shall not be primarily intended to avoid or reduce capital requirements;
internal hedges shall be properly documented and subject to particular internal approval and audit procedures;
the internal transaction shall be dealt with at market conditions;
the bulk of the market risk that is generated by the internal hedge shall be dynamically managed in the trading book within the authorised limits; and
internal transactions shall be carefully monitored.
Monitoring must be ensured by adequate procedures.
the activities the institution considers to be trading and as constituting part of the trading book for capital requirement purposes;
the extent to which a position can be marked‐to‐market daily by reference to an active, liquid two-way market;
for positions that are marked‐to‐model, the extent to which the institution can:
identify all material risks of the position;
hedge all material risks of the position with instruments for which an active, liquid two‐way market exists; and
derive reliable estimates for the key assumptions and parameters used in the model;
the extent to which the institution can, and is required to, generate valuations for the position that can be validated externally in a consistent manner;
the extent to which legal restrictions or other operational requirements would impede the institution's ability to effect a liquidation or hedge of the position in the short term;
the extent to which the institution can, and is required to, actively risk manage the position within its trading operation; and
the extent to which the institution may transfer risk or positions between the non‐trading and trading books and the criteria for such transfers.
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