Any time one bank takes a risk against another the probability of default exists. To offset this concern, and to support ongoing stability within the interbank market, banks have long emphasized the importance of measuring and managing counterparty risk. Yet over the past few months banks have becomes noticeably less comfortable trading with each other.
The recent deterioration in credit ratings that has hit many U.S. and European banks has led to a heightened sensitivity over counterparty risk. These apprehensions may not be voiced directly, but they become evident when front office trades that would have cleared in the past no longer do because credit lines have been reduced.
As head of the CVA desk at Societe Generale Corporate & Investment Banking (SG CIB), David Murphy has a unique vantage point on interbank relationships. “I wouldn’t want to overstate it – it’s not bringing the industry to a halt. But there is increasing focus on limiting exposures, even among global banks. And that is starting to affect the way we do business.”
CVA desks have grown in popularity as banks seek more effective ways to manage and aggregate counterparty credit risk. From his seat at SG CIB, David has a bird’s eye view on the challenges associated with establishing CVA desks, and the benefits banks can realize by gaining an active view on their portfolio of credit risk.
Life used to be different – at least in terms of how counterparty credit risk was calculated. In the past, an interest rate swap would have been priced the same for every client. But Lehman’s default, and more recently the Greek sovereign stress, has changed all that. Now, no client is assumed to be truly risk free. Different prices are now expected for different clients on that same interest rate swap, depending on variables including the client’s rating and the overall direction of existing trades between both parties.
“I wouldn’t want to overstate it – it’s not bringing the industry to a halt. But there is increasing focus on limiting exposures, even among global banks. And that is starting to affect the way we do business.”
Noting their emergence, and particularly their activity in the sovereign CDS market, the Bank of England defined CVA desks in their 2010 Q2 report as follows:
A commercial bank’s CVA desk centralises the institution’s control of counterparty risks by managing counterparty exposures incurred by other parts of the bank…CVA desks will charge a fee for managing these risks to the trading desk, which then typically tries to pass this on to the counterparty through the terms and conditions of the trading contract. But CVA desks are not typically mandated to maximise profits, focusing instead on risk management.
The Bank of England’s summary captures the classic model for running a CVA desk, which Murphy has implemented at SG CIB. The classic approach incorporates three elements:
1. pricing of new trades
2. transferring risk to a centralized desk from individual desks
3. hedging or otherwise mitigating the aggregated risk on a global basis
On all new interest rate, FX, equity, or credit derivatives, CVA desks price the marginal counterparty risk for inclusion into the overall price charged to the client.
CVA is a highly complex calculation – and manually calculating that for the thousands of trades and potential trades that pass through a bank every day isn’t realistic. An effective automated system therefore becomes crucial to a CVA desk’s viability.
Upsides of automation
“For a plain vanilla trade with another bank done on an electronic trading platform, our target delivery time for the price is approximately 10 milliseconds,” says David. “On the other end of the complexity spectrum, highly-structured, long-dated trades may require two or three days to calculate the CVA price. Within this range we deliver CVA pricing within timescales that don’t delay the overall trade completion.”
While automated pricing copes well with vanilla products and the speeds required for those trades, there will always be exotic trades, trades where clients have a non-standard credit story, or a trade with special risk mitigation. In these cases, David has a team of four who provide this manual pricing to Sales and Traders on request.
“We try to reduce the need for manual pricing as much as possible, but the business will always have trades where they need someone to take a closer look.”
“We try to reduce the need for manual pricing as much as possible, but the business will always have trades where they need someone to take a closer look. There may also be situations where we think the automated pricing isn’t good enough, so we want to take a look anyway and we don’t allow the sales or trades to use the automated pricing provided,” he explains.
In the manual process, the CVA desk team often passes along suggestions to the salesperson for improving the credit risk in a trade and enabling the sales person to offer the trade at a lower credit price. Examples of that would include improving the collateral agreement with a client, or inserting a break clause.
“Via the manual process, we have educated our sales team and traders how they can change the credit risk (and reduce the price). With this knowledge, they now use the automated pre-deal CVA calculations to provide several CVA prices for different versions of the same trade. This allows them to achieve the best price for the client – while minimizing the counterparty risk.”
“Really, what our sales team are interested in, is earning as much as possible net of the CVA. Through the automated system tools, we’ve empowered sales and traders to do trades with the lowest CVA possible. So it’s worth their while spending time looking for that price, and they can now do that themselves quickly and efficiently – without the delays or extra resources required when using the manual pricing process.”
These ‘pre-deal’ checks are purely indicative – and optional for Sales and Traders. But if they don’t do this check, they face a big risk, because every time a new trade is booked, an ‘official’ CVA fee is then auto-calculated – which is then recorded alongside the trade – and will be deducted from the Sales/Trader performance.
Perils of pricing
“A key challenge of building a CVA pricing system is ensuring real-time access to data in three categories: trade details; static data (client data such as rating, details of all pre-existing trades, netting status, collateral details etc), and market data.”
Acquiring actual live market data is a crucial step towards accurately pricing any trade. If an FX rate from the previous night is used, the simulations will all be using the wrong spot FX rate and all of the bank’s projected exposures will either be under or overstated.
“Through the automated system tools, we’ve empowered sales and traders to do trades with the lowest CVA possible.”
”Designing the system which has reliable and timely data in all 3 categories is crucial, given the impact that will have on pricing and/or hedging decisions. It’s a tough market with sophisticated competitors: if we under-price a risk, you can be sure we will start attracting a large market share. And if we over-price, then we lose business unnecessarily.”
Halfway to hedging
Murphy’s first priority for SG CIB has been to ensure the CVA desk correctly prices the risk in all new trades. Now that this process is well-advanced, the desk will start to focus more on hedging – or otherwise mitigating – its legacy portfolio of credit risks. “For hundreds of years banks have managed reasonably well hedging 0% of their counterparty risk. So instead of an instant seismic shift to 100% hedging of all risks, we will be hedging selected segments of the credit and market risk – which avoids paying away all CVA income to the market,” says Murphy.
For banks evolving the CVA function, there are two main reasons hedging is not further along. The first is technology: they may not yet be fully confident in their risk measurement system, which requires a complex and time-intensive development period. The second reason is strategic: the bank might not think that all of its potential hedges are very useful.
“If you take SG CIB’s total portfolio of clients, just over 10% have a liquid CDS curve. In other words, for 90% of our clients, if we wanted to go and buy CDS protection, we couldn’t do it because there’s no market. To hedge these illiquid risks, banks would need to use some kind of credit index.”
But this is an imperfect hedge. In ‘normal’ times, the credit spread of the index and the ‘generic’ spread applied to calculate the client’s CVA will move in tandem. The hedge is therefore effective in reducing earnings volatility from day-to-day changes in the CVA Reserve. But, if the client deteriorates – or even defaults – due to an idiosyncratic reason, then the index hedge may not be affected at all (i.e. the hedge doesn’t work). So the decision whether to hedge illiquid names depends on what you want to protect against: actual losses following default’…or earnings volatility caused by changes in market credit spreads.
Accounting for Basel
In the traditional CVA approach, a bank accepts a new trade, takes a fee and uses that fee to buy good hedges for all the risks in that trade. These hedges should eliminate all of the bank’s risk, but this is not necessarily the case once Basel III is taken into account.
Basel III does not recognize all types of hedges that the bank might want to use. Therefore the regulatory capital for certain trades will not be zero, even if the bank has used the full CVA fee to hedge all its risks.
The first impact Basel III has on CVA desks is on pricing. Pre-deal pricing needs to be reviewed to ensure the costs of imposed regulatory capital are covered. If not, additional pricing may need to be added. And the decision on which risks are efficient to hedge also becomes affected not just by strategic or business reasons, but also by the regulatory capital impact.
As part of Basel III’s updated regulatory capital guidelines, a new element has been added: VaR on CVA. Regulators have specified very precisely how the underlying CVA must be calculated for this charge. Banks will therefore need to decide whether to adjust their pricing and balance sheet CVA to match the BIII rules, or to use different CVA calculations for pricing and Regulatory purposes
A defining role
When individual trading desks own risk, one desk may have had a positive exposure to a client. This could lead the desk to hedge the positive exposure, without knowing that there was a negative exposure at another desk, which means the hedge wasn’t really necessary. Because the CVA desk owns all the risk from all the different derivatives desks, it has a full view of the risks with each counterparty, across all desks, products and locations and can price and hedge the risk appropriately.
It has been suggested that a CVA desk is just a ‘smart middle office’. Murphy doesn’t agree: “The main difference between CVA other front office trading functions is that most of the risks are originated internally from the bank’s other trading desks. But the CVA desk must price, originate, and distribute those risks in exactly the same way as any other front office trading desk.”
CVA desks have evolved to price, centralize, and manage a bank’s counterparty risks, requiring sophisticated modeling of hybrid risks encompassing every asset class that the bank is involved in. When implemented correctly, CVA desks should support an institution’s business and strategic vision, while helping banks maintain normalized relationships and control risk in an ever more complex trading universe.