The xVA Challenge. Gregory Jon

of not too much short of $1 trillion to purchase distressed assets and support failing banks. In November 2008, Citigroup – prior to the crisis the largest bank in the world, but now reeling following a dramatic plunge in its share price – needed TARP assistance via a $20 billion cash injection and government backing for around $300 billion of loans.

      The contagion had spread far beyond the US. In early 2009, the Royal Bank of Scotland (RBS) reported a loss of £24.1 billion, the biggest in British corporate history. The majority of this loss was borne by the British government, now the majority owner of RBS, having paid £45 billion3 to rescue RBS in October 2008 (in June 2015 the UK government announced plans to sell the majority of their RBS stake at a price around around 25 % less than they acquired it for). In November 2008 the International Monetary Fund (IMF), together with other European countries, approved a $4.6 billion loan for Iceland after the country’s banking system collapsed in October. This was the first IMF loan to a Western European nation since 1976.

      From late 2009, fears of a sovereign debt crisis developed in Europe driven by high debt levels and a downgrading of government debt in some European states. In May 2010, Greece received a €110 billion bailout from Eurozone counties and the IMF. Greece was to be bailed out again (and has since defaulted on an IMF loan) and support was also given to other Eurozone sovereign entities, notably Portugal, Ireland and Spain. Banks again were heavily exposed to potential failures of European sovereign countries. Again, the counterparty risk of such entities had been considered low, but was now extremely problematic and made worse by the fact that sovereign entities generally did not post collateral.

      By now, it was clear that no counterparty (triple-A entities, global investment banks, retail banks and sovereigns) could ever be regarded as risk-free. Counterparty risk, previously hidden via spurious credit ratings, collateral or legal assumptions, was now present throughout the global financial markets. CVA (credit value adjustment), which defined the price of counterparty risk, had gone from being a rarely used technical term to a buzzword constantly associated with derivatives. The pricing of counterparty risk into trades (via a CVA charge) was now becoming the rule and not the exception. Whilst the largest investment banks had built trading desks, complex systems and models around managing CVA, all banks (and some other financial institutions and large derivatives users) were now focused on expanding their capabilities in this respect. Banks were also becoming acutely aware of their increasing costs of funding and capitalising their balance sheets.

      2.3 Regulatory reform

      Despite the CRMPG initiatives, regulatory capital requirements and accounting rules aimed at counterparty risk, a major financial crisis had occurred with failures or rescues of (amongst others) AIG, Bear Stearns, Lehman Brothers, Fannie Mae, Freddie Mac and the Royal Bank of Scotland. The crisis highlighted many shortcomings of the regulatory regime. For example, Basel II capital requirements were seen to produce insufficient capital levels, excessive leverage, procyclicality and systemic risk.

      From 2009, new fast-tracked financial regulation started to be implemented and was very much centered on counterparty risk and OTC derivatives. The US Dodd–Frank Wall Street Reform and Consumer Protection Act 2009 (Dodd–Frank) and European Market Infrastructure Regulation (EMIR) were aimed at increasing the stability of the over-the-counter (OTC) derivative markets. The Basel III rules were introduced to strengthen bank capital bases and introduce new requirements on liquidity and leverage. In particular, the completely new CVA capital charge was aimed directly at significantly increasing counterparty risk capital requirements. Additionally, the G20 agreed a clearing mandate whereby all standardised OTC derivatives be cleared via central counterparties with the view that this would, among other things, reduce counterparty risk. Later, the G20 introduced rules that were to require more collateral to be posted against those OTC derivatives that could not be cleared (bilateral collateral rules). Other regulatory rules such as the leverage ratio and liquidity coverage ratio would also have significant impacts on the derivatives market.

      Although not driven as much by the recent crisis, IFRS 13 accounting guidelines were introduced from 2013 to replace IAS 39 and FAS 157. IFRS 13 provided a single framework for the guidance around fair value measurement for financial instruments and started to create convergence in practices around CVA. In particular, IRFS 13 (like the aforementioned FAS 157) uses the concept of exit price, which implies the use of market-implied information as much as possible. This is particularly important in default probability estimation, where market credit spreads must be used instead of historical default probabilities. Exit price also introduces the notion of own credit risk and leads to DVA as the CVA charged by a replacement counterparty when exiting a transaction.

      2.4 Backlash and criticisms

      The above regulatory changes are not without controversy and criticism. Of course there is the obvious complaint that banks will suffer much higher costs in transacting OTC derivatives. This will make them less profitable and higher costs will ultimately also be passed on to end-users. For example an airline predicted more volatile earnings “not because of unpredictable passenger numbers, interest rates or jet fuel prices,” but rather due to the OTC derivatives it used.4 End-users of derivatives, although not responsible, were now being hit as badly as the orchestrators of the global financial crisis. A negative impact on the economy in general was almost inevitable.

      However, more subtle were the potential unintended consequences of increased regulation on counterparty risk. The regulatory focus on CVA seemed to encourage active hedging of counterparty risk so as to obtain capital relief. However, the CDS transactions that were most important for such hedging (single-name and index OTC instruments) introduced their own form of counterparty risk, which was the wrong-way type highlighted by the monoline failures. Indeed, the CDS market is even more concentrated than the overall OTC market and has become less, rather than more, liquid in recent years. Problems could be seen as early as 2010 when, for example, the Bank of England commented that:5

      … given the relative illiquidity of sovereign CDS markets a sharp increase in demand from active investors can bid up the cost of sovereign CDS protection. CVA desks have come to account for a large proportion of trading in the sovereign CDS market and so their hedging activity has reportedly been a factor pushing prices away from levels solely reflecting the underlying probability of sovereign default.

      Since it was the new CVA capital charge that was partially driving the buying of CDS protection that in turn was apparently artificially inflating CDS prices, there was a question over the methodology (if not the amount) for the additional capital charges for counterparty risk. This led to the controversial European exemptions for CVA capital, discussed later in Chapter 8.

      Questions were also raised about the central clearing of large amounts of OTC derivatives and what would happen if such a CCP failed. Since CCPs were likely to take over from the likes of Lehman, Citigroup and AIG as the hubs of the complex financial network, such a question was clearly key, and yet not particularly extensively discussed. Furthermore, the increased collateral requirements from CCPs and the bilateral collateral rules were questioned as potentially creating significant funding costs and liquidity risks. In particular, the fact that initial margin (overcollateralisation) was to become much more common was a concern.

      Perhaps the most vociferous criticism was for the DVA component under IFRS 13 accounting standards. DVA required banks to account for their own default in the value of transactions and therefore acted to counteract CVA losses. However, many commentators believed this to be nothing more than an accounting trick as banks reported profits from DVA simply due to the fact that their own credit spread implied they were more likely to default in the future. Some banks aimed to monetise their DVA by selling protection on their peers, a sure way to increase, not reduce, systemic risk. Basel III capital rules moved to remove DVA benefits to avoid effects such as “an increase in a bank’s capital when its own creditworthiness deteriorates.” Banks then had to reconcile a world where their accounting standards said DVA was real but their regulatory capital rules said it was not.

      2.5 A new world

      Other changes in derivative markets were also taking place. A fundamental assumption

3

Hundreds of billions of pounds were provided in the form of loans and guarantees.

4

“Corporates fear CVA charge will make hedging too expensive”, Risk, October 2011.

5

See www.bankofengland.co.uk/publications/Documents/quarterlybulletin/qb1002.pdf.