Published: November 04, 2013
Credit Valuation Adjustment, the conceptually simple, yet operationally challenging, metric that emerged as an accounting stipulation in 2000, is attracting attention – and debate – as a result of the inclusion of a CVA VaR capital requirement in Basel III. The decision to include an explicit capital requirement stems from the observation by the Bank of International Settlements (BIS) that nearly two thirds of losses that banks suffered during the credit crisis emanated from un-hedged CVA volatility, whereas only one third could be directly attributed to actual default. CVA will capture potential mark-to- market changes related to fluctuations in the credit quality of a bank’s counterparties.
South Africa has been awarded a stay of execution – the SARB directive D3/2012 permits a zero risk weight for CVA on ZAR-based derivatives and derivatives with local counterparties for 2013, pending the finalisation of a centralised counterparty for over-the-counter (OTC) derivatives in South Africa. However, banks agree that it is not just about meeting a regulatory requirement – the rationale behind quantifying and managing CVA is prudent risk management practice.
While the degree of implementation varies, the end game is a centralised group, the CVA desk, whether this involves leveraging vendor solutions or offshore capabilities. Given the degree of counterparty concentration, as well as the lack of CDS contract coverage, respondents have generally adopted a pragmatic approach to managing CVA. Banks have tended to focus initially on those counterparties and transactions which are the largest drivers of the CVA charge. Considering the relative size of the interest rate and FX derivatives markets, it is not surprising that implementation efforts are focused on these asset classes.
Addressing whether CVA charges are uniformly included in pricing, buy-side survey respondents have observed pricing differences that they attribute to the introduction of CVA in pricing, sourced across all banks operating in the South African market. Feedback suggests that CVA may, however, be excluded for particular transactions for relationship reasons, in instances where there is cross-subsidisation from other areas of the business, or where banks deem that collateral agreements are sufficiently robust.[[[PAGE]]]
One of the ways that banks can reduce the CVA capital charge is by entering into bilateral Credit Support Annex (CSA) agreements with their clients, which require the client to post and receive collateral. Some of the larger buy-side institutions report being approached by banks seeking to educate on the pricing impact of various collateral arrangements, such as adjusted thresholds (A collateral threshold is the unsecured credit exposure limit that both counterparties will accept before they request collateral), minimum transfer amounts (MTAs) and amended CSA terms. In an effort to achieve improved pricing, a number of the buy-side respondents expressed a willingness to amend existing CSAs, or have already done so. Corporate clients have tended to be reluctant to enter into bilateral CSAs due to the administrative burden of servicing collateral as well as the potentially detrimental cash flow implications – diverting cash from operations at a time when the corporate may need it most. Mandatory break clauses have been identified as a potentially more palatable solution. A mandatory break clause breaks the deal after a specified period, effectively shortening the life of the credit exposure.
The CVA calculation is a function of the derivative exposure, PD and recovery rate. The exposure variable of the CVA calculation is generally estimated through Monte Carlo simulation of underlying risk factors. Future exposures for complex products may be estimated by using more vanilla products as proxies, or by using the current or a scenario based mark-to-market (MtM). While efforts are made to source probability of default and recovery rate information from current CDS markets, the low liquidity and market breadth of the South African CDS market forces respondents to adopt some form of mapping approach. In the absence of consensus on best practice, default probability derivation was discussed more generally. Suggestions included mapping internal counterparty ratings to historical and/or market-based default and recovery information, introducing bond proxies, using an observable index to extrapolate beyond observable tenors, and the development of proprietary industry or geographical proxies in conjunction with a spread to cater for idiosyncratic risk.
The European Bank Authority’s June 2012 Basel III monitoring exercise reveals that the introduction of CVA capital charges resulted in an average Risk Weighted Assets (RWA) increase of 7.8% for Group 1 and of 3.8% for Group 2 European banks. [1]
As the CVA VaR charge in Basel III can have a significant impact on regulatory capital requirements, the extent to which banks are able to effectively hedge CVA is viewed as a key source of competitive advantage. Consensus is for the measurement and management of market risk and credit risk sensitivities of CVA desk portfolios. When it comes to hedging the CVA exposure, South African market realities again pose a serious challenge. Not only are there no CDS contracts on the vast majority of derivatives counterparties, but even where they do exist, low liquidity and limited tenor buckets are constraints.
The exemption of European banks from CVA capital charges on trades with corporates, sovereigns and pension funds has attracted interest. The European exemption within the fourth Capital Requirements Directive (CRD IV) was based on the arguments that (1) the CVA capital charge is difficult to calculate given that so few of the European corporates have a liquid CDS contract, (2) the relative importance of corporates to the total counterparty pool, and (3) that it was punitive towards institutions that are unable to shift to exchange-traded products that do not attract CVA charges.
Survey respondents believe comparable arguments hold true in South Africa. In addition, if the exemption becomes more broadly accepted, maintaining the charge for these counterparties could result in regulatory arbitrage, prejudicing the local banking market. Respondents are concerned that, if the cost of executing OTC transactions becomes too prohibitive for corporate clients in particular, that this could result in a significant shift in the industry.
According to the BIS, the notional amount outstanding of the global OTC derivatives market was US$647tr as at December 2011. The Financial Stability Board (FSB) Peer Review of South Africa reveals that the notional value of the South African OTC market was estimated at R27.7tr in June 2012. Of this, interest rate derivatives were estimated to comprise 85% of the total, foreign-exchange contracts 12%, with the balance made up of equities, credit and commodities. The majority (59%) of OTC interest rate transactions were estimated to be conducted in the interbank market. [2]
At the Pittsburgh summit in 2009, the G20 Leaders agreed that “all standardised OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest. OTC derivative contracts should be reported to trade repositories. Non centrally-cleared contracts should be subject to higher capital requirements.”
In 2011, the G20 Leaders further agreed to add margin requirements on non centrally-cleared derivatives. As a member of the G20, South Africa has committed to implementing these reforms, addressing them through the framework of the Financial Markets Act. Survey feedback reveals a duality in the South African financial landscape: while the financial market infrastructure is being frantically developed to address these reforms, participants are in a holding position, waiting for further clarity from authorities and to see what other market participants will do.
Centrally-cleared derivatives attract a lower capital charge. Basel III permits banks to apply a 2% risk weight to cleared exposures, provided that the Central Counterparty (CCP) meets guidelines set by the Committee on Payment and Settlement Systems (CPSS) and the International Organisation of Securities Commissions (IOSCO). Rather than mandate the clearing of standardised contracts, South African authorities hope that this will provide sufficient incentive to participants to fulfil this G20 commitment.[[[PAGE]]]
The JSE’s subsidiary, Safcom, has recently been certified as a qualifying central counterparty for exchange-traded products – becoming the first in the world to qualify for CPSS-IOSCO compliance. In March 2013, the JSE further announced the promulgation of rules enabling the establishment of a default fund. These initiatives form part of the JSE’s plans to launch an onshore domestic OTC CCP – an area of major focus for the JSE.
In the interim, and to cater for the significant interbank trade between South African and offshore banks, National Treasury has granted approval until December 2013 for rand and foreign currency to be used as initial and variation margin.
As at June 2012, approximately R8.5 tr [3] worth of interest rate derivatives were traded between South African and offshore banks – based on figures presented in the FSB Peer Review report. FA News reported that Absa concluded the first South African cross-border standardised OTC derivatives transaction cleared using an offshore CCP – LCH.Clearnet in the UK – in January 2013 [4]. Although banks anticipate a push to clear through a local clearing house, they are concerned about the appetite of their offshore interbank counterparties to clear through a domestic CCP.
Buy-side views around these developments vary widely. For some survey respondents, posting initial and variation margin was not viewed as a stretch too far from their existing bilateral CSA agreements. Others expressed concern that margining would introduce undesired complications and inefficiencies in cash flow management. Concerns were also raised over restrictions on the assets that would be eligible as collateral. While some respondents welcomed greater pricing transparency from the standardisation of contracts, others viewed the lack of positioning anonymity to be disadvantageous. For many, bespoke structures form an integral part of their investment strategy and they decried that advantages, such as tax benefits, would be eliminated by a move to standardised contracts.
Central clearing and standardisation should, in theory, lead to increased volume, tighter spreads, lower margins, and a more commoditised market. However, respondents expressed concern that, initially, the move could result in fragmentation, lower liquidity and increased costs.
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