On June 11, 2021, ISDA and the Association for Financial Markets in Europe (AFME) submitted a joint response to the European Banking Authority (EBA) on its consultation on draft regulatory technical standards on the residual risk add-on (RRAO) in the Fundamental Review of the Trading Book (FRTB). Article 325u(2) of the Capital Requirements Regulation provides guidance on the meaning of instruments referencing an exotic underlying and instruments bearing other residual risks. Instruments referencing exotic underlyings can be identified as soon as they have underlying exposures to risk factors that are outside the scope of the sensitivity based method or the default risk charge components of the FRTB standardized approach. The consultation paper has further specified a non-exhaustive list of instruments bearing residual risks, and a list of risks that do not constitute residual risks.

The industry appreciates the EBA’s efforts in developing regulatory standards to identify instruments exposed to residual risks. The RRAO constitutes a sizable part of the overall capital charge, so it is important to adequately define the perimeter of in-scope instruments and consider the appropriate level of the incremental capital charge and recognize the risk-reduction benefits of hedges where appropriate. This remains a key concern for the industry – in particular, the punitive treatment of constant maturity swap spread options.