The board of the Emirates Securities and Commodities Authority (SCA) has held a meeting, presided over by its chairman, H.E. Eng. Sultan bin Saeed Al-Mansoori, who is also the Economy Minister, during which the board approved a draft resolution on capital adequacy regulations for securities and commodities brokers and broker dealers.
H.E. Sultan bin Nasir Al-Suwaidi, UAE Central Bank Governor, H.E. Abdullah Salim Al-Turifi, SCA Chief Executive, H.E. Sami Dha'en Al-Ghamzi, Director General of Dubai's Department of Economic Development and H.E. Mahmoud Ibrahim Mahmoud, were all present at the 15th meeting of the board's 3rd session, which was held in Dubai.
The board's approval of the draft regulations is part of the SCA's efforts to improve the performance standards of securities and commodities brokers and broker dealers and to boost their expertise in the management of the risks involved in their activities, including credit risk, market risk and operational risk. It is also to correspond with the special requirements of sideline trading systems and the rules governing brokers' trading for their own interest to ensure they adhere strictly to the capital adequacy rules of engagement.
The approval also followed several studies conducted by the SCA, which compared notes on various capital adequacy systems being implemented by advanced and emerging markets in countries like the United States, Malaysia, England, Singapore, Egypt, Jordan and Oman, before finally making a decision that picked the best practices and regulations being implemented on international markets in this regard.
The resolution adopted liquidity and risk regulations as the yardstick for assessing capital adequacy for brokerage companies. With regard to liquidity regulations, the net capital of the liquidity is to be calculated in percentage of the company's commitment in such a way that it will always match with the size of the company's activities and its ability to determine and control them according to its wish and its ability to increase the size of its activities. As for the risk regulations the capital is to be earmarked to enable the company face adequately all credit, market and operational risks, whether provision had been made for them or not in the company's budget allocation. They are to be calculated regularly and accurately to reflect the true picture of the company's financial status, its capital adequacy and its ability to meet its obligations towards its clients to win the trust of investors.
The resolution also outlined the requirements and regulations of capital adequacy and rules on how to face credit, market and operation risks, general obligations, internal assessment of capital adequacy and the company's publishing of information related to its capital adequacy, strategies, systems and objectives for managing such risks and exposures.
Moreover, the resolution took into consideration the Basel 2 regulations and developments on the local, regional and international markets, following the world economic crisis.
The resolution urged all concerned companies to abide strictly by the regulations and to the methods of calculation as outlined in the guidebook and the capital adequacy form attached to the resolution.
Capital Adequacy
Regarding the capital requirements, the resolution demands that a broker must hold sufficient capital to correspond to credit risk, market risk, and operational risk and in accordance with articles (3, 4, 5).
For the purposes of calculating the broker’s required capital, the resolution defined own funds to mean:
1. Original own funds (Tier 1): Equity + contributions and revaluation reserves - losses during a current financial year - intangible assets
2. Additional own funds (Tier 2): include subordinated debt instruments with an original term to maturity of not less than five years.
3. Expanded own funds (Tier 3): net gains attributable to the Broker's trading book and subordinated loans with an original term to maturity of not less than two years. The Broker shall deduct non-liquid assets from the expanded own funds [tier 3 capital].
For the purposes of calculating a broker's capital adequacy, the values of the assets in the broker's portfolios are to be valued in accordance with the provisions of the attached guidelines. But in any case, tier 1 capital is never less than tier 2, the resolution states.
Credit Risk
With regards to credit risks, the resolution states that a capital shall have to correspond to not less than 14 percent of the Broker's risk-weighted exposure amounts calculated in accordance with the attached guidelines. But upon calculation of the risk-weighted amount for a certain exposure, a Broker may take into consideration such security, guarantees and other collateral as reduce the credit risk inherent in the exposure. Consideration and calculation of credit risk mitigation shall be conducted according to the detailed capital adequacy rules and according to the capital adequacy model. Assets can be divided into sub classes, such that risk weights shall be determined in accordance with those set to match risk classes determined by credit rating agencies.
Market Risk
For market risks, the resolution demands that the capital is required to amount to the total of the capital requirements for, counterparty risks for trading book operations, settlement risks for trading book operations, position risks (interest rate and share price risks) for trading book operations and foreign exchange risks and commodity risks in the entire operations. But all capital requirements for market risk shall be calculated in accordance with the attached guidelines, the resolution adds.
Calculating the Market Risk
In calculating the market risk, the resolution states that a broker may, pursuant to authorization by the Authority, calculate the capital requirement in accordance with Article (3), taking into consideration counterparty risks and where the total market value of the positions in the trading book and receivables attributable thereto, normally, does not exceed 5 percent of the sum of the Broker's balance sheet total and total off balance sheet undertakings; or normally, does not exceed an amount equivalent to AED75 million; and on no occasion, exceeds 6 percent of the Broker's balance sheet total and total off-balance sheet undertakings, nor exceeds an amount equivalent to AED100 million.
Operational Risk
Touching on the Operational risks, the resolution states that they include those that result from processes, systems and persons or external ones including legal risks, whereby a broker is to hold sufficient capital for operational risks using one of the following approaches: (1) Ensuring that the capital requirement for operational risks shall correspond to not less than 25 percent of the Broker’s fixed overhead (Expenditure based approach), (2) ensuring that upon application of the Basic Indicator Approach, the capital requirement for operational risks shall equal 15 percent of the average of the annual operating income during the three most recent financial years or of another calculation basis which corresponds to the operating income and (3) ensuring that they are in accordance with a standardized approach, as per the attached guidelines. Only one of the above methodologies is to be used for the calculation of capital requirements for operational risks, the resolution added.
General Obligations
Article 6 of the resolution outlines a number of general obligations, including a demand that the value of a Broker's exposures to a single counterparty, or group of connected counterparties who can be considered as one entity from a risk perspective, may not exceed 25 percent of the Broker's own funds. Moreover, the total value of a Broker's large exposures may not exceed 800 percent of the Broker's own funds.
Meanwhile, a large exposure, according to the resolution, is an exposure which a Broker has to counterparty or group of connected counterparties where the value of the exposure is 10 percent or more of the Broker's own funds. The resolution defines "Group of connected counterparties" as meaning two or more natural or legal persons who, unless otherwise shown, constitute a single risk because: (1) either one of them, directly or indirectly, has control over the other or others in the group; or (2) they are so interconnected that if one of them were to experience financial problems, the other or all of the others would be likely to encounter repayment difficulties.
With respect to a financial group, the resolution states that responsibility for fulfillment of the requirements on a consolidated basis shall be borne by the Broker which is not a subsidiary of another Broker; or whose parent undertaking is a financial holding company which is not a subsidiary of a Broker. Where the holding company is a parent undertaking to two or more Brokers, the Broker which has the largest balance sheet total shall be responsible for ensuring that the requirements on a consolidated basis are fulfilled.
Internal Capital Adequacy Assessment Process
Article 8 of the resolution outlines internal capital adequacy assessment process. It demands that every Broker must furnish the SCA with its internal capital adequacy assessment procedure, which must include its robust governance arrangements, including a clear organizational structure with well defined, transparent and consistent lines of responsibility, effective processes to identify, manage, monitor and report the risks it is or might be exposed to, and adequate internal control mechanisms, including sound administrative and accounting procedures.
Regarding the publication of Information, the resolution states that a broker shall publish information which concerns its capital adequacy and its strategies, systems and objectives for managing such risks and exposures.