MVA taking the long road to acceptance

Four years on, the adjustment is still not a standard part of non-cleared swap pricing

The term ‘margin valuation adjustment’ (MVA) was introduced in the pages of Risk magazine in April 2015, when Andrew Green and Chris Kenyon published their paper MVA by replication and regression. The pair spelt out the concept of a derivatives valuation adjustment (XVA) covering the cost of posting initial margin (IM) under new rules that would be phased in from the following year.

Up to this point, there had been a certain inevitability about new derivatives valuation adjustments introduced post-crisis. Credit valuation adjustment was already well established, but from around 2010 the concept of funding valuation adjustment (FVA) – the cost of funding uncollateralised or imperfectly collateralised positions – moved from being a hotly debated theoretical topic to an accepted part of pricing. It really came out of the shadows when JP Morgan incurred a $1.5 billion loss incorporating FVA into its accounts in 2014.

Once the major banks adopted FVA into their pricing, others followed. When applied to their accounting frameworks, it led to losses of more than $6.2 billion across the Street.

An adjustment for the cost of capital covering a position (KVA) emerged in early 2015 and also caught on quickly. And more specialised adjustments such as replacement valuation adjustment, which covers the cost of a dealer having to replace itself in a swap with a securitisation vehicle if it is downgraded too far, were quickly accepted as standard not long after being mooted.

So it seemed it was only a matter of time before MVA joined the other XVAs as a standard practice in derivatives pricing. In July 2016, dealers were already talking about pricing MVA on an ad hoc basis, with one CVA trading head calling it “the new guy everyone is worried about”. 

While implicitly priced in for cleared trades, MVA is still struggling for acceptance in the non-cleared world. There are several reasons for this. 

For one, the phased roll-out of the IM rules meant it did not catch the majority of dealers until this year. Even then, IM is only applied to new trades, and only if the gross exposure is less than €50 million. 

The initial groups of dealers brought into scope of the rules were relatively sophisticated firms, and most had centralised XVA desks armed with optimisation tools to reduce their non-cleared exposures.  

On the client side, only the very largest hedge funds and asset managers are currently caught by the IM requirement, with more to come over the next two years. 

In many cases, pricing MVA into client trades is a business decision – most banks will try and find a way to optimise the existing portfolio to free up margin, rather than slap the client with an additional charge that might lose them the trade or damage the relationship.

That’s not to say it should be ignored. In a recent webinar, XVA traders agreed that MVA is taking time to grow but, as IM balances inevitably expand, banks need to think about what that means for pricing. This is particularly the case for clients with directional positions, whose trades by their very nature attract more IM with every new line-item.

Whether MVA will eventually end up as a standard component of pricing, or even an accounting adjustment, is hard to say. But it seems the heady days of the early to mid-2010s, when every obscure derivatives cost discovered by a quant was immediately incorporated into standard market pricing, are far behind us.

 

XVA – Special report 2019
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