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By Nosheen Khan and Paul Jones, Markit
By Nosheen Khan and Paul Jones, Markit
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A Timely Revolution In Credit Value Adjustment

The new regulatory environment demands that credit value adjustment be both marked to market and actively hedged. Fortunately, powerful analytics tools have emerged to meet the need for fast, accurate and flexible exposure measurement and management, according to Markit's Nosheen Kahn and Paul Jones.

Intense scrutiny of counterparty risk systems and practices, as a result of the deficiencies exposed by the financial crisis, has brought about a heightened focus on the need to quantify and manage counterparty credit risk accurately and an accelerated shift from passive to active management of counterparty risk. Establishing a price, or the credit value adjustment (CVA), for counterparty credit risk, rather than simply controlling counterparty risk through the use of credit limits, has been practiced for more than a decade. But early practice was essentially static, with no marking to market of the CVA charges paid by traders. Today, the new regulatory environment for capital demands that CVA be both marked to market and actively hedged.

The change in how institutions manage default exposure also is being driven by ongoing adoption of more sophisticated market practices and significant advances in technology and analytics. Competitive pressure is another factor, and front offices recognize that integrating more refined CVA into pre-deal pricing and structuring improves profit and loss potential.

The complex modeling techniques demanded by CVA need immense processing power. Technological advances have emerged to meet the need for fast, accurate and flexible exposure measurement and management. These powerful analytics tools enable simulation-based, near real-time computation of incremental CVA, which takes account of offsetting positions to reflect economic risk; and active hedging of CVA risk.

Importantly, today's solutions combine high-speed computational performance with small deployed footprints. The effects of new technology are pronounced in stress testing, and user-friendly frameworks to define bespoke stress scenarios at the trade, counterparty and book levels and generate results in near real-time are now available.

In addition, improved technology is enabling the management of multiple products within a single counterparty risk system, including exotics. Until recently, capturing economic risks and payoffs, running sensitivity analysis, and producing competitive prices was too complex for instruments such as target asset return notes and callable range accruals. Advances enable complex payoffs and other bespoke trade features to be incorporated efficiently without significant programming.

Hedging CVA Risk

A continuing challenge faced by the industry is the absence of a standard market to hedge CVA risk. Although attempts have been made to develop an active market in contingent credit default swaps (CCDS) for hedging purposes, liquidity and participation remain limited.

Securitization has been explored as an alternative, with some dealers attempting to apply structured credit techniques. This approach involves creating a synthetic CDO from a bespoke basket of CCDS and selling tranches to investors to transfer counterparty risk. However, securitization of CVA has its own set of problems. Among these is valuation, which is made more complex by the issue of blind pools, which exist because counterparty names cannot be disclosed. Basel III, which does not provide capital relief for CVA securitization, presents an additional obstacle.

The evolution of credit support annexes (CSAs), which govern the posting of collateral, also may have a significant bearing on how CVA develops. Currently, collateral terms in CSAs ignore the fact that there is a free option relating to the cheapest-to-deliver currency. The debate over whether the option is economic and will be exercised has implications for CVA calculations. Pricing of the optionality would require simulations to value even the simplest of interest rate swaps. There is still significant uncertainly about the rules, and one approach to increasing fungibility and ease of CVA calculation involves migrating to more standard collateral terms.

Progress Toward Holistic Counterparty Credit Risk Management

Despite these challenges, the financial markets are making progress in adopting a more comprehensive, integrated approach to counterparty credit risk management. For example, financial institutions are now focusing more attention on the management of wrong-way risks -- portfolios in which the counterparty's probability of default is highly correlated with the underlying exposure.

With wider bank spreads in the aftermath of the financial crisis, incorporating funding costs into CVA is another priority. As a result, an additional measure in the shape of FVA (funding value adjustment) is being introduced alongside CVA, and banks are beginning to incorporate funding considerations into the models used to value their derivative positions. At the same time, by quantifying the risk they themselves pose to counterparties through the debt value adjustment (DVA) process, institutions are becoming more sophisticated about offsetting the potential cost created by CVA and developing tools within the CVA framework to help them compete for trading business.

While the introduction of central clearing counterparties to mitigate counterparty credit risk has an obvious bearing on the CVA market's future, many transactions will remain outside the remit of central clearing, as will exempt end-users, such as sovereigns. Meanwhile, we continue to see innovation in the CVA market through new technologies that enable market participants to adopt faster, more accurate CVA pricing and more active hedging techniques.

Next Page: CVA and Regulatory Compliance

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