Time to Review Misconceptions in Derivatives and Counterparty Risk
Ultimately, the 2008 crisis brought about an extraordinarily stark revelation of the structural weaknesses of the financial system, as it enabled everyone, including regulators, not only to become aware of the lack of control of financial markets, but, above all, of the imperfections, not to say the inaccuracies, of the valuation models of financial assets, in particular of credit products and derivatives.
An over-the-counter derivative is basically a credit product and its valuation must effectively integrate counterparty risk. This translates into a credit charge, known as the Credit Valuation Adjustment (CVA), which reflects the bank’s loss expectation in the event of a default by its counterparty. In fact, several value adjustments are added to the price of derivatives, in particular those relating to financing costs (Fund Valuation Adjustment: FVA) and banks cost of capital (Capital Valuation Adjustment: KVA). The sum of these adjustments is called xVA and it is easy to imagine the confusion and frustration of corporate treasurers facing their pricing softwares which have become obsolete, as well as the complexity of the models and the financial expertise required for the valuation of a derivative nowadays.
The economics at stake are real for many companies in industries such as telecommunications, aerospace, the automotive industry, energy or project finance, and can easily represent several tens of millions of euros in certain types of transactions, or even a significant part of a company’s net profit.
Credit Charges only Appeared in 2008/2009 and Concern but Large Companies
In reality, the CVA concept was introduced in the late 1990s, mainly by US investment banks, and the consequence was that their swap quotes were often off-market, although they were modelled correctly.
Today, the vast majority of banks have fully integrated counterparty risk using modern quantitative models, with the resulting credit charges applying to all customers: large and small, corporates, pension funds, etc.
"Nevertheless, corporates or their advisers will inevitably have to update their derivative valuation systems and will have to fully integrate counterparty risk in order to meet IFRS 9 requirements."
Banks Levy Credit Charges but Never Pay Them Back to their Clients
This is nowadays less and less true: the trend is reversing at the instigation of a few large investment banks that have fully integrated a bilateral approach to credit and financing charges.
Imagine the astonishment of this corporate treasurer, when the bank that he has just asked for a quote for the unwind of an interest rate swap tells him that the required payment is not 10 million euros as his treasury software predicted, but only 6 million, or a 40% discount! For the bank, it was financially more advantageous to pay the company an extra 4 million euros, representing all the value adjustments, rather than keeping the transaction on its balance sheet and retaining the associated credit risk. These cases are quite common today when it comes to interest rate hedges contracted at much higher levels than current levels and banks are increasingly willing to release credit provisions to companies, at least in part.
Conversely, Companies are Not Remunerated for the Credit Risk They Incur towards their Banks
There remains a debate regarding the Debit Value Adjustment, or DVA, the symmetric quantity of CVA, which represents the expected loss of the company in case of a default of its bank counterpart. Many banks argue that their default risk is already included in the calculation of FVA through the cost of financing. In reality, these banks do not wish to integrate DVA in their prices because monetising DVA amounts to trading in their own credit default swap, which they cannot do.
There again, some investment banks are ahead and pay a significant part of DVA through a clever replication of their own credit risk. For a corporate treasurer, the corollary of this is that there remains a great diversity of methodologies and it is therefore essential to know which one is employed by his bank before executing any transaction, especially if it can be restructured or unwound, as future quotes will greatly depend on the method employed.
Competitive Bidding Results in the Best Market Price
While competitive bidding used to always be simple and effective in obtaining the best market price, this is no longer the case. This may sound shocking but we are dealing with a market where the price not only depends on the seller but primarily on the buyer and what he already has in his shopping trolley.
The explanation for this lies mainly in the fact that the risk generated by any new transaction is more or less correlated with the risk of the portfolio already in place with the bank counterparty in question and this has very different effects on the pricing of any new transaction.
In practice, it is common to see a bank systematically aligning itself to the best price when quoting or even proposing to execute at mid. This almost always indicates that the new transaction generates a significant credit or financing gain for the bank in question, which can amount to dozens of basis points, in particular for currency hedges or unwinds of positions. In such cases, it is better not to go ahead with the transaction but rather analyse in detail the xVA parameters with the best-quoting bank.
The Economic Impact of a Novation from one Bank to Another is Relatively Limited
This is the least obvious misconception as a novation (transferring an existing position from one bank to another) does not have any impact on the market. There again, the credit and portfolio effects are such that the relative difference in value of a novation can reach half the market value of a position, or even more.
It should be pointed out that any change in documentation may have a significant economic value, even for credit support annexes, the purpose of which is precisely to eliminate any credit risk. This year, a large corporate has greatly improved its net profit following a renegotiation of this type.
What are the Solutions for Treasurers?
Collateralisation is the first response that regulators have attempted to impose on large firms through clearing and NFC+ classification but with limited success given the liquidity risk that it induces and also the potential impact on debt ratios. This is an inaccessible solution for many companies and we should mention totally abstruse situations such as where the hedge of a private placement of 150 million euros generates a financing requirement of 100 million euros. However, this is a solution that has the advantage of eliminating a significant part of the value adjustments, provided that high thresholds are not required.
The introduction of the new Markets in Financial Instruments Directive (MiFID II) from 2018 onwards ought to encourage banks to provide much better information to their clients and ensure greater transparency on the pricing of transactions.
Nevertheless, corporates or their advisers will inevitably have to update their derivative valuation systems and will have to fully integrate counterparty risk in order to meet IFRS 9 requirements. Current treasury softwares are not designed to handle the complexity of xVA adjustments, however, there are specific solutions that provide easy access to expertise equivalent to that of the banks.
Finally, a modern banking relationship on a level playing field remains the best way to embrace these evolutions without suffering from them. Some large corporates have successfully carried out a thorough review of the credit and xVA methodologies of their bank counterparties enabling them today to anticipate credit issues and optimise the management of their derivative portfolios.