The argument that derivatives valuation adjustments, known as XVAs, should be found in exit prices in order for them to qualify as accounting adjustments is not new.
Existing accounting standards require that financial instruments be recorded at fair value. The International Financial Reporting Standard (IFRS) 13 defines fair value as an exit price, or a price that would be received to sell an asset or paid to transfer a liability in a transaction between two parties.
Whether exit price is the only way to account for the fair value of a derivative is contentious, though.
Market participants have often complained that the margin valuation adjustment (MVA), which reflects the cost of funding the initial margin on a derivatives trade, is not observable in prices, so lacks a clear exit price.
This is because MVA is not being charged systematically by banks at the moment – possibly as a strategy to win trades, or because banks want to wait until after they have compressed and optimised their books to reduce initial margin costs.
Also, since MVA is a funding cost, it is entity-specific – the cost will depend on your existing portfolio with a counterparty. So, building a consensus on the price that everyone would be willing to pay can get tricky. As a result, banks are yet to report MVA in their accounting books – at least explicitly, anyway.
But new research shows accounting standards around fair value offer a lot more flexibility than people think.
In this month’s first technical, Accounting for derivatives with initial margin under International Financial Reporting Standard 13, Richard Kenyon, a senior lecturer at Birmingham City University and Chris Kenyon, head of the XVA quantitative research team at Lloyds Banking Group in London, argue that according to the IFRS 13 text, entity-speciﬁc considerations can be factored into the fair value.
“How you account for it is a bit more flexible, because the accounting standards themselves allow you to reflect the realities of your management of the trade, including even manager’s compensation, so it may even revolve around idiosyncratic ways of trading,” says Kenyon.
The authors argue that while measuring fair value, IFRS 13 asks to consider the principal market or the most advantageous market for the trade. Since different entities have access to different markets, the authors argue this allows for differences between entities with different activities – especially on the aspects of market access. In addition, own credit status is explicitly permitted, and this feeds through into funding costs.
Novations are a good place to observe this. These are executed by end-users to close out current swap positions by re-papering the terms of agreement they have on with an existing counterparty with another bank. If counterparty A wants to exit a trade with bank B by novating it to bank C, bank C will face an incremental MVA cost or benefit, and counterparty A would have to compensate for it.
“If you are going to novate a transaction to a third party and that third party has to post initial margin, then it is rational to think that if that third party needs to fund that initial margin, it is going to cost them and they would want to factor that into the novation price,” says an executive director in the financial services assurance division at a London-based Big 4 accountancy firm. “If you could consistently see MVA clearly in novations and in new transaction pricing, auditors would have little choice but to challenge management if an MVA were not taken in books and records.”
Novations are treated as new trades under the margin rules for non-cleared derivatives, the first phase of which went live in September last year for the largest dealers. So if a novation results in two dealers facing each other, they would have to post each other initial margin. On trades entered into after September, some asset managers have been asked by banks to pay their share of the MVA cost after a novation. There is already evidence of this incremental MVA cost being charged by dealers.
Even in terms of observability within prices, thanks to the margin rules, things are beginning to change as costs rise.
For instance, once the first phase of the rules went live, dealers started warning buy-side clients about a significant increase in the fees they would have to pay for foreign exchange prime brokerage services because of initial margin funding costs on trades entered into after September 1.
Auditors say some banks might already be slipping MVA through other items in their accounting books, such as the funding valuation adjustment or fair value adjustment.
Since things have come this far, it all just boils down to one big question – who will go first in taking an accounting adjustment? We all know the usual suspects, now all that is left is for one of them to kick things off so the rest can follow.