XVA Explained

www.pwc.com.au XVA explained Valuation adjustments and their impact on the banking sector December 2015 XVA explained Introduction Background The past decade has seen a raft of The global financial crisis saw a As derivative desks have traditionally changes in the banking industry, with structural shift in the operation relied upon cheap, unsecured borrowing a focus on seemingly never-ending of the global banking sector. Two to fund their operations, this change has new regulation. changes are particularly relevant in significantly increased the funding costs One of the less well understood understanding XVA. for banks actively trading derivatives. We changes is a revision to the The first relates to the operation of have set out below a simplified illustration fundamentals of trading book fair the interbank funding market. During to highlight the differences that flowed value measurement and pricing, the crisis, and especially post the from these changes, and how they are through the gradual introduction of Lehman collapse, concerns about impacting core inputs to derivative pricing various valuation adjustments. These bank creditworthiness led to an almost and valuation concepts seen today. are far from minor tweaks to banks’ complete breakdown of the interbank balance sheets; instead they are funding market. Post the crisis, interbank having a genuine impact on earnings lending rates have been more volatile across the industry. and traded at increased spreads to the For example, one major global Central Bank rate. This has reflected investment bank reported a loss of a correction in the market view of $1.5Bn due to ‘Funding Valuation bank credit risk. Adjustments’. Also known as FVA, this has joined CVA and DVA in the Changes in inter-bank funding apparently ever-expanding list of adjustments to derivative contract valuations. What are these adjustments and where do they come from? In this article we describe the origins of FVA and the many related adjustments which go under the umbrella name Cost of funding of ‘XVA’. We then discuss how XVA affects auditors and, finally, we will look at how these are driving change in B banks’ front office teams. LIBOR/BBSW A OIS 2004 2006 2008 2010 2012 2014 A: Post GFC, there is a greater divergence between benchmark rates that were traditionally regarded as ‘risk free’ (such as BBSW and LIBOR) and the Overnight Index Swap (OIS) rate, where the OIS rate is now seen as a better proxy of the ‘risk free’ rate. B: Banks’ funding costs over and above LIBOR have increased post GFC as the market repriced bank credit risk. 2 The second significant change has been A ‘fully-costed’derivative the introduction of new regulation to ensure that the banks are adequately Adjustment Description Applicable to capitalised. These have targeted OTC Primarily uncollateralised derivative CVA (2002+) Impact of counterparty credit risk. derivative transactions, and have had assets. such an impact that trading desks have Benefit a bank derives in the event of its Primarily uncollateralised derivative DVA (2002+) needed to incorporate these changes in own default (the ‘other side’ of CVA). liabilities. pricing. Further new regulation will require Captures the funding cost of all financial sector derivatives that are not FVA (2011+) uncollateralised derivatives above the Uncollateralised derivatives. cleared through central clearinghouses ‘risk free rate’. to be collateralised (margined), in much Cost of funding a collateralised derivative OIS/COLVA (2010+) Collateralised derivatives. the same way as exchange traded position, at new ‘risk free’ rate. instruments or futures contracts. The Cost of holding regulatory capital as a All derivative contracts, more punitive KVA (2015+) costs of margining, and associated result of the derivative position. on trades that are not cleared. liquidity volatility, represents further overhead in trading derivatives. As a result of the above macro changes, we have seen the introduction of various derivative valuation adjustments, Cost of posting ‘initial margin’ against a Derivatives that are cleared, likely essentially to reflect the additional MVA (2015+) ‘costs’ in holding derivative contracts derivative position. wider population in the future. today. From an accounting perspective, in concept this is similar to an inventory Credit Valuation Adjustment (CVA) costing model, where additional costs are CVA is probably the most widely known a loan contract typically has standard being factored into unit pricing and, for • and best understood of the XVA. CVA and predictable future cashflows, existing ‘stock’, valuation. captures the ‘discount’ to the standard and therefore an easily calculated Some of these adjustments, like Credit derivative value that a buyer would offer ‘credit exposure’. Derivative cashflows Valuation Adjustments (CVA), are well given the risk of counterparty default. are highly variable and difficult to understood and already an integral part In concept, it is somewhat akin to predict. As such, sophisticated CVA of the way that banks price derivatives. credit provisions on loan assets. There calculations involve Monte Carlo Others are emerging, and many banks are are two key differences to loan loss approaches to determine the range unable to reliably quantify and compute provisions though: possible future exposures. the adjustments. • derivatives are marked to market, Currently, the industry is revisiting A key challenge is that a number of these requiring a ‘market price’ to accept the blanket use of CDS rates in CVA adjustments need to be calculated on a the risk of counterparty default. This calculations. This is due to reduced portfolio basis, not trade by trade. This is often calculated by reference to the liquidity in CDS contracts, flowing has led to changes in bank structures. cost of hedging the counterparty credit from lower participation by banking The required changes in IT infrastructure, risk on the contract, through credit intermediaries reacting to banking organisational reporting lines and front default swaps (CDS); regulation such as the Volcker rule. office staffing are proving costly, ironically adding further costs to trading functions. 3 Debit Valuation Adjustment (DVA) DVA is a rather counter intuitive notion as the market value of the derivative, the it involves recording a gain as the bank’s remainder being a windfall to the bank’s own credit risk deteriorates. bondholders. This windfall benefit is Consider the situation where a bank captured in DVA. trades an uncollateralised OTC derivative. DVA is normally computed in much the Assume now that the bank defaults same way as CVA, and is often thought when the derivative is ‘out of the money’. of as ‘the other side’ of CVA (ie. a bank’s The counterparty to the derivative DVA is its counterparty’s CVA). typically recovers only a proportion of Funding Valuation Adjustment (FVA) Standard derivative valuation models be used to fund other ventures, in lieu of used in most banking and corporate raising external funding. The value of the treasury systems assume a discount funding benefit can be seen as the rate at rate based on benchmark rate (LIBOR which the bank can raise cash, which is or BBSW). These models therefore based on its credit quality. FBA therefore assume the time value of money, or has significant overlap with DVA. funding rate available to the bank, is the Similarly, a funding cost arises for the benchmark rate. As outlined at the onset bank when a derivative has a positive of this paper, post-GFC there has been market value. The purchase of an ‘in a significant divergence in the cost of the money’ or asset position derivative funding available to a bank versus the requires the bank to pay cash. The benchmark rate. FVA attempts to capture incremental cost of funding this purchase the cost of funding uncollateralised can also be seen as equivalent to the OTC derivatives. FVA is divided into two cost of the bank raising funding. FCA is component adjustments, being: also therefore a function of the bank’s • Funding Benefit Adjustment (FBA), and credit quality, and is calculated typically • Funding Cost Adjustment (FCA). using the same rate as FBA. A funding benefit arises for the bank Note that unlike the FBA/DVA overlap, typically when the derivative has a FCA is more distinct from CVA, as FCA negative market value (liability). Consider is based on the bank’s own funding the case where a bank acquires a cost (and credit quality), whereas CVA derivative in a liability position. The bank is based on the credit quality of the will accept this liability in exchange for bank’s counterparty. cash. The cash received by the bank can 4 Collateral Valuation Adjustment (COLVA or OIS) Posting collateral (margin) against a such, receiving collateral on a derivative derivative position significantly alters reduces the need to otherwise fund that both the credit risk and funding profile position at a more expensive rate. The of that position. converse holds true for positions that are A perfectly collateralised derivative has out of the money. COLVA or OIS captures no credit risk, and therefore requires no this cost or benefit. CVA (or DVA). In practice though, these There are several complications in the situations are rare due to operational calculation of OIS, given the range of practicallities in posting collateral, so collateral that can be posted under credit risk is rarely completely eliminated. existing contracts (ranging in cash The collateral received against an in-the- in different currencies to different money trade typically means the receiving securities). Some banks have developed bank pays interest at the overnight sophisticated tools to ensure they are cash funding rate (approximated by the posting the ‘cheapest to deliver’ collateral Overnight Index Swap, or OIS, rate). As given the range of options. Capital Valuation Adjustment (KVA) Banks are required to hold capital Consistency of KVA across the industry reserves in order to survive large is difficult as some banks have standard unexpected credit, market or operational capital models, whereas others use risk losses.

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