The xVA Challenge. Gregory Jon

assumed to be risk-free. Market practice, regulation and accounting standards have changed dramatically over recent years in reaction to these aspects.

      Finally, there are many third parties in the OTC derivative market. These may offer, for example, collateral management, software, trade compression and clearing services. They allow market participants to reduce counterparty risk, the risks associated with counterparty risk (such as legal) and improve overall operational efficiency with respect to these aspects.

3.1.5 Credit derivatives

      The credit derivatives market grew swiftly in the decade before the global financial crisis due to the need to transfer credit risk efficiently. The core credit derivative instrument, the credit default swap (CDS), is simple and has transformed the trading of credit risk. However, CDSs themselves can prove highly toxic: whilst they can be used to hedge counterparty risk in other products, there is counterparty risk embedded within the CDS itself. The market has recently become all too aware of the dangers of CDSs and their usage has partly declined in line with this realisation. Credit derivatives can, on the one hand, be very efficient at transferring credit risk but, if not used correctly, can be counterproductive and highly toxic. The growth of the credit derivatives market has stalled in recent years since the crisis.

      One of the main drivers of the move towards central clearing of standard OTC derivatives is the wrong-way counterparty risk represented by the CDS market. Furthermore, as hedges for counterparty risk, CDSs seem to require the default remoteness that central clearing apparently gives them. However, the ability of central counterparties to deal with the CDS product, which is much more complex, illiquid and risky than other cleared products, is crucial and not yet tested.

3.1.6 The dangers of derivatives

      Derivatives can be extremely powerful and useful. They have facilitated the growth of global financial markets and have aided economic growth. Of course, not all derivatives transactions can be classified as “socially useful”. Some involve arbitraging regulatory capital amounts, tax requirements or accounting rules. As almost every average person now knows, derivatives can be highly toxic and cause massive losses and financial catastrophes if misused.

      A key feature of derivatives instruments is leverage. Since most derivatives are executed with only a small (with respect to the notional value of the contract) or no upfront payment made, they provide significant leverage. If an institution has the view that US interest rates will be going down, they may buy US treasury bonds. There is a natural limitation to the size of this trade, which is the cash that the institution can raise in order to invest in bonds. However, entering into a receiver interest rate swap in US dollars will provide approximately the same exposure to interest rates but with no initial investment.11 Hence, the size of the trade, and the effective leverage, must be limited by the institution themselves, the counterparty in the transaction or a regulator. Inevitably, it will be significantly bigger than that in the previous case of buying bonds outright. Derivatives have been repeatedly shown to be capable of creating or catalysing major market disturbances with their inherent leverage being the general cause.

      As mentioned above, the OTC derivatives market is concentrated in the hands of a relatively small number of dealers who trade extensively with one another. These dealers act as common counterparties to large numbers of end-users of derivatives and actively trade with each other to manage their positions. Perversely, this used to be perceived by some as actually adding stability – after all, surely none of these big counterparties would ever fail? Now it is thought of as creating significant systemic risk: where the potential failure in financial terms of one institution creates a domino effect and threatens the stability of the entire financial markets. Systemic risk may not only be triggered by actual losses; just a heightened perception of losses can be problematic.

3.1.7 The Lehman experience

      The bankruptcy of Lehman Brothers in 2008 provides a good example of the difficulty created by derivatives. Lehman had more than 200 registered subsidiaries in 21 countries and around a million derivatives transactions. The insolvency laws of more than 80 jurisdictions were relevant. In order to fully settle with a derivative counterparty, the following steps need to be taken:

      • reconciliation of the universe of transactions;

      • valuation of each underlying transaction; and

      • agreement of a net settlement amount.

As shown in Figure 3.3, carrying out the above steps across many different counterparties and transactions has been a very time-consuming process. The Lehman settlement of OTC derivatives has been a long and complex process lasting many years.

Figure 3.3 Management of derivative transactions by the Lehman Brothers estate.

      Source: Fleming and Sarkar (2014).

      3.2 Derivative risks

      An important concept is that financial risk is generally not reduced per se but is instead converted into different forms; for example, collateral can reduce counterparty risk but creates market, operational and legal risks. Often these forms are more benign, but this is not guaranteed. Furthermore, some financial risks can be seen as a combination of two or more underlying risks (for example, counterparty risk is primarily a combination of market and credit risk). Whilst this book is primarily about counterparty risk and related aspects such as funding, it is important to understand this in the context of other financial risks.

3.2.1 Market risk

      Market risk arises from the (short-term) movement of market variables. It can be a linear risk, arising from an exposure to the movement of underlying quantities such as stock prices, interest rates, foreign exchange (FX) rates, commodity prices or credit spreads. Alternatively, it may be a non-linear risk arising from the exposure to market volatility or basis risk, as might arise in a hedged position. Market risk has been the most studied financial risk over the past two decades, with quantitative risk management techniques widely applied in its measurement and management. This was catalysed by some serious market risk-related losses in the 1990s (e.g. Barings Bank in 1995) and the subsequent amendments to the Basel I capital accord in 1995 that allowed financial institutions to use proprietary mathematical models to compute their capital requirements for market risk. Indeed, market risk has mainly driven the development of the value-at-risk (Section 3.3.1) approach to risk quantification.

      Market risk can be eliminated by entering into an offsetting contract. However, unless this is done with the same counterparty12 as the original position(s), then counterparty risk will be generated. If the counterparties to offsetting contracts differ, and either counterparty fails, then the position is no longer neutral. Market risk therefore forms a component of counterparty risk. Additionally, the imbalance of collateral agreements and central clearing arrangements across the market creates a funding imbalance and leads to funding costs.

3.2.2 Credit risk

      Credit risk is the risk that a debtor may be unable or unwilling to make a payment or fulfil contractual obligations. This is often known generically as default, although this term has slightly different meanings and impact depending on the jurisdiction involved. The default probability must be characterised fully throughout the lifetime of the exposure (e.g. swap maturity) and so too must the recovery value (or equivalently the loss given default). Less severe than default, it may also be relevant to consider deterioration in credit quality, which will lead to a mark-to-market loss (due to the increase in future default probability). In terms of counterparty risk, characterising the term structure of the counterparty’s default probability is a key aspect.

      The credit risk of debt instruments depends primarily on default probability and the associated recovery value since the exposure is deterministic (e.g. the par value of a bond). However, for derivatives the exposure is uncertain and driven by the underlying market risk of the transactions. Counterparty risk is therefore seen as a combination of credit and market risk.

3.2.3 Operational and legal risk

      Operational risk arises from people, systems and internal and external events. It includes human error (such as trade entry mistakes), failed

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Aside from initial margin requirements and capital requirements.