Dodgy discounts: DVA claims fly in cross-currency market

Funding benefits have helped bring down the cost of cross-currency swaps in the past couple of years, but as competition becomes increasingly cut-throat, traders claim their rivals are offering a dodgier discount – the own-credit effects of debit valuation adjustment

Traders distrust DVA because the theoretical gain that arises when a bank's own credit spreads widen is difficult to monetise

A surge in euro borrowing by corporates over the past year has been supported by a dramatic narrowing of dealer charges for cross-currency swaps – a result of fierce competition among dealers, as well as the industry's increasing confidence in recognising the funding benefits these trades can generate. In some cases, though, pricing has become so cheap banks claim it can only be explained by the use of a widely derided adjustment for a dealer's own risk of default.

Critics say the debit valuation adjustment (DVA) is being used to offset and even overwhelm the credit valuation adjustment (CVA) charge that represents the client's counterparty risk, with the end result that the family of add-ons applied to the price – known as XVAs – can slip into negative territory, implying a bank would pay a premium to do the trade.

"You have your initial CVA, add on your return, take off your funding and your DVA and that takes it negative. It's the first time I've ever seen it," says one London-based senior rates source. The head of rates structuring at a European bank in London puts the blame in the same place: "It feels like people are aggressively looking at DVA and giving a large benefit for it."

Of the 14 traders that spoke to Risk for this article, only one admitted to incorporating DVA when working out the XVA charge. But the market is telling a different story.

One trader says he would generally expect rival banks to quote within a basis point of each other for a euro/US dollar cross-currency swap – the product's most liquid currency pair – but during 2015 found himself missing trades by up to 3bp. Another rates trading source talks of bidding for a 10-year cross-currency swap in recent months: his XVA price was 8bp, and the client got the trade at a negative spread.

In some cases, this has resulted in the rate received by the dealer dipping below the market's mid price. Receiving below mid and then hedging the trade at the level available in the interbank market would lose the bank money – that is, before taking into account the funding and other benefits the trade can provide in the long run.

"It's pricing us out of the market," says the rates trading source.

Stories like these are not hard to find, and are often accompanied by a sad shake of the head. Traders distrust DVA because the theoretical gain that arises when a bank's own credit spreads widen – cutting the value of its liabilities – is difficult to monetise. It should not be handed to clients in the form of a discount, critics argue (see box: DVA hedging: a cautionary tale).

 

You have your initial CVA, add on your return, take off your funding and your DVA and that takes it negative. It's the first time I've ever seen it – a London-based senior rates source

 

The idea that it is becoming more prominent worries some dealers. They see it as a trick used to gain an edge in trades with corporates – a slice of the derivatives business that is becoming increasingly competitive.

"Banks are making efforts to chase corporate business," says Pascale Moreau, global co-head of fixed income and derivatives sales at Societe Generale Corporate & Investment Banking (SG CIB) in Paris. "It's funny to see the different communications from banks as they go through their strategy reviews, with paragraphs here or there saying they will favour that kind of business."

The emergence of DVA as a decisive factor in pricing has its roots in the low-interest rate environment, and the rush by corporates to take advantage. With the European Central Bank expected to continue its quantitative easing programme until at least March 2017, and the US Federal Reserve finally raising rates on December 16, the eurozone has become a popular place for corporates to raise cash, a theme that is expected to continue throughout this year.

US corporates have been leading the way – according to data from Dealogic, they issued €65.5 billion of euro-denominated bonds in 2015 up to December 16, compared with €38.6 billion in 2014 – an increase of 70% (see figure 1). Once the euros are raised, US issuers often look to swap them back into US dollars. The trade sees corporates exchanging the euro notional amount of their bond issuance for US dollars upfront at the spot rate, then paying US dollar Libor and receiving euro Libor – minus a cross-currency basis spread – for the life of the trade. The two counterparties then re-exchange the principal amounts at the end of the trade, at the initial foreign exchange rate.

This gives the dealer a euro liability for a trade that can have a maturity of 10 years or more. With the forward points implying an eventual appreciation of the euro against the US dollar, the liability portion of the trade is expected to rise in value for the dealer, while its asset portion will fall. In other words, the dealer will be out-of-the-money for much of the trade.

While this seems to be a bad trade for the bank, it's actually helpful for a few reasons. First, as it's likely to owe money to a counterparty rather than the reverse for most of the trade, its leverage and counterparty credit risk exposures are smaller, resulting in lower capital requirements.

Second, as the corporate trade is uncollateralised, and would – simplistically – be hedged with a collateralised swap in the interdealer market, it creates a funding benefit for the dealer. This is because the bank will be receiving variation margin from its hedge counterparty, but will not have to pass it on to the corporate client – resulting in a funding benefit adjustment (FBA) that is one half of the so-called funding valuation adjustment (FVA). The trading desk can theoretically monetise this by lending the FBA to its internal treasury, receiving the bank's funding spread as interest.

A growing minority, however, believe it is more often used to offset its larger twin, the funding cost adjustment (FCA), and so can't be monetised per se. Nevertheless, the FBA is generally seen as monetisable, and so is included as a discount to the overall XVA adjustment to a trade price. So, when a bank quotes a euro/US dollar cross-currency swap, it will charge an adjustment for the counterparty's CVA – which, if uncollateralised, can be large – and the capital consumption for the lifetime of the trade, known as KVA. It will then subtract the FBA.

If the corporate has a low counterparty risk, and the quoting bank has a high funding spread, the FBA can be enough to wipe out the CVA and KVA completely – even without DVA in play. Traders say this is legitimate.

Two rates traders claim to have seen XVA charges move into the negative when providing the market hedge for a cross-currency swap – a manoeuvre in which one or more banks initially trades with a client, and then novates to another group of swap providers that have more appetite to face the client and take the counterparty risk. The first bank – the market risk taker – then acts as the hedge for the credit risk providers.

"As recently as last week, we had provided the market hedge for a client and then syndicated the credit. Some of the banks quoting the cross-currency swaps were quoting negative spreads, so they were effectively paying to take on those positions," says the London-based head of risk solutions at one large dealer, speaking in early December.

XVA benefit

Anshul Sidher, global head of rates and local markets at ANZ in Singapore says it's not just in cross-currency swaps where the bank has seen negative XVA spreads. "Even a single cashflow swap, where we are paid an upfront amount, with a term repayment under no credit support annex, will have a substantial XVA benefit as it contributes to funding the bank to term. This will be a liability on balance sheet, with no CVA or risk-weighted assets (RWAs), and therefore spreads could go negative," he says.

The risk solutions head says he has been seeing negative XVA spreads more often over the past six months, which he puts down to the increasing ability of other banks to price complex funding effects. "Banks are becoming more and more capable of monetising the value of that funding, more risk aware, and more capable of pricing against a sophisticated model that takes into account CVA, FVA and KVA," he says.

These factors, along with the increased competition for these trades, have effectively come to the rescue of the cross-currency swap market which, until relatively recently, was being viewed primarily through the lens of capital and RWAs only – and, as a result, was problematic for many dealers.

 

Even a single cashflow swap, where we are paid an upfront amount, with a term repayment under no credit support annex, will have a substantial XVA benefit – Anshul Sidher, ANZ

 

But there is a limit. If the trade is long-dated, the exposure profile will always be somewhat uncertain, meaning CVA will always be a factor for an uncollateralised trade. In addition, the big funding benefits that can wipe out capital and counterparty adjustments only appear in certain cases. If a lower-rated client is facing a strong bank, a negative XVA spread is harder to justify – here, traders say the addition of a DVA discount is the only explanation for low or negative spreads.

DVA has always been unpopular among dealers. It has been part of US accounting standards for years, and has also been formally included in international accounting standards since 2013. It is expressed as a profit or loss on a firm's liabilities, following a change in its counterparty credit risk, observed from credit spreads (see figure 2).

Traders accept this makes some sense as an accounting construct – if an issuer has become less creditworthy, then its bonds will be less valuable – but many are dismissive of the idea it should be reported as a profit, and are opposed to incorporating it into prices as a discount.

Critics cite the difficulty in realising the paper gains associated with DVA. Take the easiest theoretical hedge of a bank's DVA: buying its own bonds. When the bank's creditworthiness rises, the resulting DVA losses would be offset by an increase in value of the bonds and vice versa. This involves actually buying the cash bonds, however, making it very expensive. Banks could sell credit default swap protection on themselves instead, but would not be around to pay out on the contract.

"From a purely risk management point of view, from the bank and shareholder view, it doesn't really make any sense. It's not monetisable," says Jerome de Vasconcelos, head of CVA trading at SG CIB in London.

"For most people I speak to, DVA is a great intellectual and academic concept, but it isn't a concept for trading and risk management. So a lot of firms don't price it. But some do, ending up in cases where you introduce a client and you're paying them to bring this risk to you," he adds.

Another argument against pricing DVA lies in its treatment in the capital framework. While DVA profits and losses would hit the income statement, which feeds into equity, the effects are not recognised in a bank's regulatory capital numbers.

"There is this stigma on paying out DVA to clients, because the common valuation approach removes DVA from the capital measure of own funds. So if you don't consider the DVA, then by definition you shouldn't pay it out to clients for putting a cross-currency swap or any other derivative on your book," says the head of interest rate modelling at another European bank.

Breaking ranks

That is the orthodox view. Some traders have been willing to break ranks in the past, banks say, but it has never been so common – possibly because DVA has rarely offered this type of decisive advantage in such a competitive market. The suspicion is that dealers are essentially using DVA to snatch a trade from under their rivals' noses.

Unless a bank is syndicating a trade, however, or is given explicit feedback from clients on how their rivals are pricing their XVA charges – enabling the different components to be reverse-engineered – dealers say they can only guess whether rival banks included their own credit risk in the price.

To make matters more complicated, everyone defines DVA differently. This is due to the significant crossover between DVA and FBA – both are tied to changes in the bank's own credit spreads. Some banks think about DVA as an increment on top of FBA, for instance, while others focus on the latter and ignore the former.

"Some banks will use CVA, and then FCA and FBA, but not DVA, while others will use CVA and DVA. You wouldn't do both because then you're double counting," says the head of forex sales at one US dealer.

Hedgers and their advisers say it is becoming more common for banks to use DVA as a way of giving themselves a competitive edge.

"I know people are looking at it [pricing DVA] very actively. Those that want to look at it more actively want to be more competitive than others – it's all about making sure your derivatives business is efficient and competitive," says one derivatives expert at an advisory firm in London.

Some harbour other theories. SG CIB's De Vasconcelos suggests some may be including DVA because they're struggling to hedge their CVA adequately in the increasingly illiquid credit default swap (CDS) markets.

"A lot of CVA desks are short gamma and having to buy volatility, and are rushing to find the same CDS in the market, which is difficult. And some people seem to have a much easier life, and it turns out they're using DVA for that," he says.

Richard Pattison, head of the cross-currency swap and credit support annex desks at Lloyds Bank Commercial Banking in London, speculates that reporting of DVA pricing at some institutions may have begun by a trader covering himself for writing a trade too cheaply.

"The cynic within me would say if someone wanted to write the business and ran out of other XVAs to allege, they might well justify writing an optically loss-making trade by saying ‘Have you considered the DVA?' And that's how it gets started," he says.

 

DVA hedging – a cautionary tale

In 2011, two large US banks are said to have tried to mutually hedge their debit valuation adjustment (DVA) numbers using a complex structure in which each would enter into a bilateral forward on their own credit default swap (CDS) with each other. According to a trader involved in the negotiations at the time, the trade, which had a notional amount set to run into the billions, involved the one-year-forward sale of a five-year CDS, settling every year for cash and knocking out if there was a credit event during the one-year period.

If the spread got tighter – because Bank A's short-term creditworthiness improved – then Bank A would receive the benefit as variation margin, and vice versa.

Each bank would hedge the trade by buying rolling one-year CDS protection on its counterparty and selling a five-year CDS on the same name. The two dealers would do the structure in reverse so both banks' DVA was hedged.

The trade did not clear the final hurdle, failing to get approval from senior management at one of the banks. A primary concern was the lack of liquidity in the CDS market.

"Senior management said it was the best thing they had seen so far on the topic of DVA. But in the end they were not convinced enough to enter into long-dated hedges based on single-name CDSs, which were an increasingly illiquid product," says the trader.

One of the US banks also looked to sell the product to small Italian and German banks, the trader claims. Unlike the US, however, European CDS contracts can also be triggered by restructuring events. The post-restructuring settlement procedure places the one- and five-year contracts into different recovery buckets, meaning the payouts can be different – a situation that hurts the economics of the trade.

The EU's Market Abuse Directive also caused concerns. As the trades were in such large size, it is likely they would have a significant impact on the hedging bank's CDS spreads. "If, ultimately, some senior person decides to execute something that is related to your own spread, it might be seen as manipulating the market," says the trader.

Once Deutsche Bank announced it was exiting the market for non-cleared single-name CDSs in 2014, further attempts to apply the structure were shelved, the trader adds, as liquidity would be even harder to obtain.

It's not the first attempted DVA hedge. Before the 2008 crisis, one large US bank was said to have hedged its DVA by selling large amounts of protection on an index of financial issuer CDS spreads. The logic was that the seller's creditworthiness was correlated to that of its peers in the index, and if one bank in the index went down the seller would likely collapse as well, meaning it would not have to pay out on the contracts it sold. When Lehman Brothers filed for bankruptcy in September 2008, the index soared and the protection seller survived - albeit at the cost of huge losses on its DVA hedge.