The xVA Challenge. Gregory Jon

an institution enters into a forward FX contract to exchange €1m for $1.1m at a specified date in the future. The settlement risk exposes the institution to a substantial loss of $1.1m, which could arise if €1m was paid but the $1.1m was not received. However, this only occurs for a single day on expiry of the FX forward. This type of cross-currency settlement risk is sometimes called Herstatt risk (see box below). Pre-settlement risk (counterparty risk) exposes the institution to just the difference in market value between the dollar and Euro payments. If the foreign exchange rate moved from 1.1 to 1.15, this would translate into a loss of $50,000, but this could occur at any time during the life of the contract.

      Unlike counterparty risk, settlement risk is characterised by a very large exposure – potentially, 100 % of the notional of the transaction. Whilst settlement risk gives rise to much larger exposures, default prior to expiration of the contract is substantially more likely than default at the settlement date. However, settlement risk can be more complex when there is a substantial delivery period (for example, as in a commodity contract where one may be required to settle in cash against receiving a physical commodity over a specified time period).

      Whilst all derivatives technically have both settlement and pre-settlement risk, the balance between the two will be different depending on the contract. Spot contracts have mainly settlement risk whilst long-dated swaps have mainly pre-settlement (counterparty) risk. Furthermore, various types of netting (see Chapter 5) provide mitigation against settlement and pre-settlement risks.

      Case study: Bankhaus Herstatt

      A well-known example of settlement risk is the failure of a small German bank, Bankhaus Herstatt. On 26th June 1974, the firm defaulted but only after the close of the German interbank payments system (3:30pm local time). Some of Herstatt Bank’s counterparties had paid Deutschemarks to the bank during the day, believing they would receive US dollars later the same day in New York. However, it was only 10:30am in New York when Herstatt’s banking business was terminated, and consequently all outgoing US dollar payments from Herstatt’s account were suspended, leaving counterparties fully exposed.

      Settlement risk is a major consideration in FX markets, where the settlement of a contract involves a payment of one currency against receiving the other. Most FX now goes through CLS18 and most securities settle DVP,19 but there are exceptions, such as cross-currency swaps, and settlement risk should be recognised in such cases.

      Settlement risk typically occurs for only a small amount of time (often just days, or even hours). To measure the period of risk to a high degree of accuracy would mean taking into account the contractual payment dates, the time zones involved and the time it takes for the bank to perform its reconciliations across accounts in different currencies. Any failed trades should also continue to count against settlement exposure until the trade actually settles. Institutions typically set separate settlement risk limits and measure exposure against this limit rather than including settlement risk in the assessment of counterparty risk. It may be possible to mitigate settlement risk, for example by insisting on receiving cash before transferring securities.

      Recent developments in collateral posting have the potential to increase currency settlement risk. The standard CSA (Section 6.4.6), the regulatory collateral requirements (Section 6.7) and central clearing mandate (Section 9.3.1) incentivise or require cash collateral posting in the currency of a transaction. These potentially create more settlement risk, and associated liquidity problems, as parties have to post and receive large cash payment in silos across multi-currency portfolios.

4.1.3 Mitigating counterparty risk

      There are a number of ways of mitigating counterparty risk. Some are relatively simple contractual risk mitigants, whilst other methods are more complex and costly to implement. Obviously, no risk mitigant is perfect, and there will always be some residual counterparty risk, however small. Furthermore, quantifying this residual risk may be more complex and subjective. In addition to the residual counterparty risk, it is important to keep in mind that risk mitigants do not remove counterparty risk per se, but instead convert it into other forms of financial risk, some obvious examples being:

      • Netting. Bilateral netting agreements (Section 5.2.4) allow cashflows to be offset and, in the event of default, for MTM values to be combined into a single net amount. However, this also creates legal riskw in cases where a netting agreement cannot be legally enforced in a particular jurisdiction and also exposes other creditors to more significant losses.

      • Collateral. Collateral agreements (Section 6.2) specify the contractual posting of cash or securities against MTM losses. Taking collateral to minimise counterparty risk creates operational risk due to the necessary logistics involved and market risk, since exposure exists in the time taken to receive the relevant collateral amount. Collateralisation of counterparty risk also leads to liquidity risk, since the posting of collateral needs to be funded and collateral itself may have price and FX volatility. Aspects such as rehypothecation (reuse) and segregation of collateral are important considerations here (Section 6.4.2 and 6.4.3). Like netting, collateral also increases the losses of other creditors in a default scenario (Section 6.6.1).

      • Other contractual clauses. Other features, such as resets or additional termination events (Section 5.5.2), aim to periodically reset MTM values or terminate transactions early. Like collateral, these can create operational and liquidity risks.

      • Hedging. Hedging counterparty risk with instruments such as credit default swaps (CDSs) aims to protect against potential default events and adverse credit spread movements. Hedging creates operational risk and additional market risk through the mark-to-market (MTM) volatility of the hedging instruments. Taking certain types of collateral can create wrong-way risk (Chapter 17). Hedging may lead to systemic risk through feedback effects (see the statement from the Bank of England in Section 2.4).

      • Central counterparties. Central counterparties (CCPs) guarantee the performance of transactions cleared through them and aim to be financially safe themselves through the collateral and other financial resources that they require from their members. CCPs act as intermediaries to centralise counterparty risk between market participants. Whilst offering advantages such as risk reduction and operational efficiencies, they require the centralisation of counterparty risk, significant collateralisation and mutualisation of losses. They can therefore potentially create operational and liquidity risks, and also systemic risk, since the failure of a central counterparty could amount to a significant systemic disturbance. This is discussed in more detail in Chapter 9.

      Mitigation of counterparty risk is a double-edged sword. On the one hand, it may reduce existing counterparty risks and contribute to improving financial market stability. On the other hand, it may lead to a reduction in constraints such as capital requirements and credit limits, and therefore lead to a growth in volumes. Indeed, without risk mitigants such as netting and collateral, the OTC derivatives market would never have developed to the size it is today. Furthermore, risk mitigation should really be thought of as risk transfer, since new risks and underlying costs are generated.

      Another way to see some of the risk conversion described above is in xVA terms. CVA may be reduced but another xVA component created. Indeed, later chapters of this book will discuss this conversion between xVA terms in detail. For now, some obvious examples are:

      • Collateral. Creates FVA (due to the need to fund collateral posting) and ColVA (due to the optionality inherent in the collateral agreement).

      • Termination clauses. Aspects such as early termination events (possibly linked to downgrade triggers) create MVA that has been exasperated due to regulatory requirements regarding liquidity buffers (Section 16.2.1).

      • Central clearing and bilateral collateral rules. The requirement to post additional collateral in the form of initial margin creates MVA.

      • Hedging. Hedging CVA for accounting purposes may create additional capital requirements and

18

A multi-currency cash settlement system – see www.cls-group.com.

19

Delivery versus payment, where payment is made at the moment of delivery, aiming to minimise settlement risk in securities transactions.