XVA S, CSA S & OTC CLEARING Plus the impact of regulation on OTC Derivatives Date November 2016 Author Darren Hooton, Business and Corporate Sales - FICC
DEMYSTIFYING SOME OF THE DERIVATIVE MARKET TLA S l XVA s the colloquial term given to the numerous adjustments banks are making to the price of derivatives. l CSA s is the credit support annexes which are potentially attached to an ISDA to cover how collateral will be paid and received. It details the type of collateral that can be provided, the currency, how much and how often. l LCH London Clearing House. Legislation in various countries requires market participants to record transactions through a clearing house like LCH and then post an initial margin plus ongoing collateral to the clearing house to cover the MTM. This is designed to significantly reduce the risk banks face against each other. l CTD Cheapest to deliver refers to the option the collateral provider has to choose the type of collateral and currency they will provide under a CSA. For example Euro s are currently cheap for some banks. 2
DEMYSTIFYING SOME OF THE DERIVATIVE MARKET TLA S l ROE Return on equity is the ratio of income generated from a transaction to the estimated capital that the regulator requires a bank to hold for the transaction expressed as a percentage l CDS Credit default swaps are a derivative contract on a counterparty that provides a payout to the buyer should the underlying counterparty default There are many more market TLA s 3
XVA S WHAT AND WHY? CVA Credit Valuation Adjustment DVA Debit Valuation Adjustment FVA Funding Valuation Adjustment KVA Capital Valuation Adjustment COL VA Collateral Valuation Adjustment MVA Margin Valuation Adjustment What The cost of hedging counterparty default risk implied by CDS The theoretical value of owndefault implied by CDS The cost of funding uncollateralised trades The cost of regulatory capital through the transaction life Cost or benefit of discounting future cash flows under OIS compared to qtly Libor The cost of funding initial margins with a clearer Why IFRS 13 exit price pushed market towards use of CDS curves IFRS 13 requires own credit adjustment and accounting symmetry Market observable prices are now collateralised/cleared Dramatic increase in regulatory capital requirements since Basel III Collateral only receives overnight interest where as banks generally discount qtly Initial margin on bilateral collateral agreements 4
WHAT DOES IT MEAN? l CVA, FVA and KVA are the big 3 in pricing uncollateralised trades, however the approaches to calculating all 3 vary significantly between banks l Existing portfolios impact CVA and KVA dramatically l Impacts increase more than linearly with tenor l Direction matters. especially cross-currency swaps l Close-out netting can dramatically reduce XVAs l CSA s or collateral agreements all but eliminate XVAs 5
REASONS FOR DIFFERENCES IN BANK PRICING l CVA valuation methodology for accounting is fairly standardised but pricing may reflect different approaches to CVA hedging. l FVA is critically dependent on the assumed funding curve of the bank. The question is should this be some blended market curve (i.e. exit price ) or an internal curve provided by the banks treasury? l KVA is generally the largest XVA but projecting regulatory capital is very dependent on assumptions. l Internal default and recovery ratings significantly impact KVA and CVA for counterparties without traded CDS curves. l Even if banks have identical approaches to all calculations, differences in existing portfolios will result in difference incremental XVA charges. 6
WHAT S HAPPENING IN THE MARKET TODAY? l CSA s corporates generally don t execute collateral agreements because the CSA converts market risk into liquidity risk. Maybe consider single deal CSA? l Turn on close out netting across the ISDA to reduce XVA s and concentrate trades with fewer banks to get more benefit from netting. l Compression transactions to reduce the amount of collateral we post to LCH for the initial margin banks are consolidating offsetting trades into one transaction. This also helps European and American banks with their leverage ratio s by reducing the face value, this legislation is coming to Australia soon. l OTC Clearing to reduce the risk in the Over The Counter derivative market significant counterparties are required to post initial margins and collateral to cover the MTM, similar to LCH. This risk with this legislation is that its extended to large corporates. 7