Published: September 02, 2011
Notwithstanding the 2007 financial crisis, the use of over-the-counter (OTC) derivatives both globally and in South Africa has grown exponentially in recent years. The total outstanding notional value of OTC derivatives was US$592tr in December 2008, according to the Bank for International Settlements, of which 70% was for interest rate derivatives. The 2008 post-Lehman collapse has focused attention on counterparty credit and default risks embedded within these derivatives.
Basel III now brings a number of changes to this environment, and one of the most significant is the so-called CVA adjustment.
The use of over-the-counter (OTC) derivatives both globally and in South Africa has grown exponentially in recent years.
For anyone unfamiliar with the concept, CVA management is an internal function which aggregates and quantifies counterparty risks across the bank. Having quantified this risk, hedging products are then priced accordingly. With the imminent introduction of Basel III this pricing impact will soon become apparent in OTC derivatives within South Africa. With this in mind, there is much that the corporate treasurer needs to begin considering right now.
There is a great deal of uncertainty about the real impact of Basel III on the global economy, and much work still has to go into quantifying each proposed amendment. But based on what we know so far, Basel III with its increased focus on derivative instruments will be a lot more onerous than Basel II. Basel III, which now explicitly provides a framework to attribute capital against CVA, could have a significant impact on derivatives, and the pricing thereof.
CVA is one of the first of many Basel III changes to be implemented and seeks to expand the risk coverage of the Basel accord, resulting in an increase in the quantum of banks capital to be allocated against counterparty credit risk on derivative instruments. Clearly, this will affect the pricing of risk and make OTC derivative instruments more expensive.
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The aftermath of the credit crisis of 2007 has changed the way financial institutions look at risk, and counterparty credit risk (CCR) in particular is an area that has received a large amount of attention.
Through the global credit crisis, which was underpinned by the failure of Lehman Brothers and other prominent institutions, many now believe that no counterparty can ever again be considered risk-free or immune to financial instability.
Many now believe that no counterparty can ever again be considered risk-free or immune to financial instability.
Pre-2007, the starting point for pricing derivative CCR was PFE (potential future exposure). PFE is a statistical calculation of the maximum exposure, at the 95th percentile confidence interval, for a future point in time. Banks took comfort that this was a reliable measure to quantify CCR and used this as a basis for their appetite and exposure.
In fact the move to price risk had begun even before the credit crisis, when in 2006 an accounting standard concerning fair value measurements, FAS 157, required that when valuing a derivative, default or non-performance risk of the counterparty must be accounted for by adjusting the value of the derivative.
The European equivalent of FAS 157 is IAS 39, which is used in South Africa. These standards require an appropriate mark-to-market of derivative positions including the possibility of future defaults. For example, FAS 157 and IAS 39 define fair value and require banks to remove from their risk-free value of derivative positions, the CVA or expected loss associated with future counterparty defaults. CVA is determined based on the cost of hedging counterparty defaults in the credit market and as such is cyclical in nature.
Then came the credit crisis of 2007, which saw the failure of Lehman Brothers and other prominent institutions and resulted in a substantial increase in the cost of hedging counterparty defaults within the credit markets. This in turn resulted in a significant increase in CVA losses for the remaining financial institutions. It was this rapid escalation of CVA losses within Banks that drew the attention of the Basel Committee on Banking Supervision and led to the introduction of a CVA capital charge.
Basel III aims to address the risk associated with CVA loss volatility, by imposing additional capital requirements on banks over and above the capital already held for a jump to default scenario. This in turn will result in an increase in pricing to the users of OTC derivatives for either trading or hedging requirements. Generally speaking the longer the tenor of a derivative instrument the larger the CVA charge and the greater the capital impact.
CVA is fairly straightforward for instruments that are linear, but become commensurately more complex for positions that are non-linear. For these instruments, CVAs do not just depend on interest rates and default risk, but also on volatility. [[[PAGE]]]
There are three main tools available to a corporate treasurer to potentially soften the impact of these developments on the pricing of OTC derivatives. These are:
1. Entering into ISDA (International Swaps and Derivatives Association) agreements;
2. Enhancing ISDAs with CSA (credit support annex) agreements; and the
3. Inclusion of break clauses.
The use of the above tools will provide varying degrees of pricing relief with the combined use of an ISDA and CSA agreement likely to provide the biggest benefit. These tools have attained wide acceptance in developed markets (US and Europe), though some of them, less so in South Africa.
The challenge going forward is that a pricing of a hedge under Basel III, could increase considerably compared with that of Basel II.
However, it isn’t that simple, as CSA agreements require collateral, mostly cash, to be posted. This will significantly add to the host of challenges already faced by the South African treasurers as cash flow projections will become even more important and difficult to manage.
South African banks have been stringent in their pricing of CCR. Post 2007, local banks have advanced and currently are able to model and price for CVA. Price making is then typically based off the CVA price. However, the challenge going forward is that a pricing of a hedge under Basel III, could increase considerably compared with that of Basel II.
In conclusion, Basel III and the emphasis on CVA, which is due to be effective from 1 January 2013, will place some stringent capital requirements on derivatives – most of which are more onerous than that of Basel II and could have a significant impact on the pricing of OTC derivatives. While the mitigants to this are admittedly not perfect, the corporate treasurer will need to consider these alternatives. There certainly seems as though there are some tough decisions looming for South Africa’s corporate treasurers - it would be prudent to consider these decisions sooner rather than later.
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