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 in the pricing of derivative securities had always been that the discounting rate could be appropriately proxied by LIBOR. However, practitioners realised that the OIS (overnight indexed spread) was actually a more appropriate discounting rate and was also a closer representation of the “risk-free rate”. The LIBOR–OIS spread had historically hovered around ten basis points, showing a close linkage. However, this close relationship had broken down, even spiking to around 350 basis points around the time of the Lehman Brothers bankruptcy. This showed that even the simplest types of derivative, which had been priced in the same way for decades, needed to be valued differently, in a more sophisticated manner. Another almost inevitable dynamic was that the spreads of banks (i.e. where they could borrow unsecured cash on a longer term than in a typical LIBOR transaction) had increased. Historically, this borrowing cost of a bank was in the region of a few basis points but had now entered the realms of hundreds of basis points in most cases.
It was clear that these now substantial funding costs should be quantified alongside CVA. The cost of funding was named FVA (funding value adjustment) which had the useful effect of consuming the strange DVA accounting requirements (from a bank’s point of view at least). Not surprisingly, the increase in funding costs also naturally led banks to tighten up collateral requirements. However, this created a knock-on effect for typical end-users of derivatives that historically have not been able or willing to enter into collateral agreement for liquidity and operational reasons. Some sovereign entities considered posting collateral, not only to avoid the otherwise large counterparty risk and funding costs levied upon them, but also to avoid the issue that banks hedging their counterparty risk may buy CDS protection on them, driving their credit spread wider and potentially causing borrowing problems. Some such entities posted their own bonds as collateral, solving the funding problems if not the counterparty risk ones. It also became clear that there was hidden value in collateral agreements that should be considered using collateral value adjustment (ColVA). Finally, the dramatic increase in capital requirements led to the consideration of capital value adjustment (KVA) and impending requirements to post initial margin to margin value adjustment (MVA).
Regulation aimed at reducing counterparty risk and therefore CVA was becoming better understood and managed. However, this in turn was driving the increased importance of other components such as DVA, FVA, ColVA, KVA and MVA. CVA, once an only child, had been joined by a twin (DVA) and numerous other relatives. The xVA family was growing and, bizarrely, regulation aimed at making OTC derivatives simpler and safer was driving this growth.
3
The OTC Derivatives Market
In my view, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal. 6
3.1 The derivatives market
Derivatives contracts represent agreements either to make payments or to buy or sell an underlying security at a time or times in the future. The times may range from a few weeks or months (for example, futures contracts) to many years (such as long-dated swaps). The value of a derivative will change with the level of one of more underlying rates, assets or indices, and possibly decisions made by the parties to the contract. In many cases, the initial value of a traded derivative will be contractually configured to be zero for both parties at inception.
Derivatives are not a particularly new financial innovation; for example, in medieval times, forward contracts were popular in Europe. However, derivatives products and markets have become particularly large and complex in the last three decades.
One of the advantages of derivatives is that they can provide very efficient hedging tools. For example, consider the following risks that an institution, such as a corporate, may experience:
• IR risk. They need to manage liabilities such as transforming floating- into fixed-rate debt via an interest rate swap.
• FX risk. Due to being paid in various currencies, there is a need to hedge cash inflow or outflow in these currencies via FX forwards.
• Commodity. The need to lock in commodity prices either due to consumption (e.g. airline fuel costs) or production (e.g. a mining company) via commodity futures or swaps.
There are many different users of derivatives, such as sovereigns, central banks, regional/local authorities, hedge funds, asset managers, pension funds, insurance companies and corporates. All use derivatives as part of their investment strategy or to hedge the risks they face from their business activities.
In many ways, derivatives are no different from the underlying cash instruments. They simply allow one to take a very similar position in a synthetic way. For example, an airline wanting to reduce their exposure to a potential rise in aviation fuel price can buy oil futures, which are cash-settled and therefore represent a very simple way to go “long oil” (with no storage or transport costs). An institution wanting to reduce their exposure to a certain asset can do so via a derivative contract, which means they do not have to sell the asset directly in the market.
The credit risk of derivatives contracts is usually called counterparty risk. As the derivatives market has grown, so has the importance of counterparty risk. Furthermore, the lessons from events such as the failure of Long-Term Capital Management and Lehman Brothers (as discussed in the last chapter) have highlighted the problems when a major player in the derivatives market defaults. This in turn has led to an increased focus on counterparty risk and related aspects.
Within the derivatives markets, many of the simplest products are traded through exchanges. A derivatives exchange is a financial centre where parties can trade standardised contracts such as futures and options at a specified price. An exchange promotes market efficiency and enhances liquidity by centralising trading in a single place, thereby making it easy to enter and exit positions.The process by which a financial contract becomes exchange-traded can be thought of as a long journey where a reasonable trading volume, standardisation and liquidity must first develop. Whilst an exchange provides efficient
Quote from 2002.
