CVA hedge losses prompt focus on swaptions and guarantees

Banks are turning to credit swaptions and guarantees to reduce the earnings volatility that arises when hedging the credit valuation adjustment capital charge in Basel III. By Lukas Becker

Since late 2012, Deutsche Bank has lost €443 million euros on hedges that cut its capital requirement for derivatives counterparty exposure – a trade-off banks face because the regulatory and accounting definitions of credit valuation adjustment (CVA) are different, meaning regulators might see a hedge as effective, while accountants do not. That problem has prompted some institutions – and individuals – to look for ways to satisfy both sets of rules.

"There are structures you can put together that do limit the volatility. You can't control it, but you can limit it," says the head of CVA trading at one European bank.

The gap between regulatory and accounting CVA occurs because the capital requirements comprise two components – Basel II's counterparty risk charge for current exposure and Basel III's CVA value-at-risk charge, which captures expected changes in derivatives counterparty risk. Accounting rules also require trades to recognise current exposures, but do not have a future exposure charge, meaning hedges of CVA VAR will be seen as naked positions, potentially leading to accounting losses.

Some banks say capital relief is more important than profit-and-loss (P&L) volatility, but the numbers can add up. Deutsche Bank, for instance, has lost quarterly sums ranging from €31 million to €166 million since the fourth quarter of 2012.

Speaking at the Risk USA conference in New York on October 22, Deutsche Bank's group chief risk officer, Stuart Lewis, defended the strategy: "Our CVA hedges have generated a fair amount of accounting volatility and the volume of hedging we do is very big – last year we had somewhere over €200 million of loss, given the fact that spreads tightened quite substantially. But it's worth it – you're always looking at the capital-accretive nature of the underlying hedge, so as long as your capital savings outweigh the hedging costs and the accreting loss on the mark-to-market then it's worth it," he said.

Last year we had somewhere over €200 million of loss, given the fact that spreads tightened quite substantially. But it's worth it

In Deutsche's case, the hedges used are believed to be largely vanilla credit default swap (CDS) products – primarily single-name contracts. Other banks say more complex variants, such as credit index swaptions – in which the buyer has the right to enter into an index CDS for a specified period of time for a certain spread – can reduce P&L volatility while still delivering a capital benefit.

The Basel III rules say only single-name CDSs, single-name contingent CDSs, index CDSs and "other equivalent hedging instruments referencing the counterparty directly" can be used to reduce the new CVA charge. An FAQ published by the Basel Committee on Banking Supervision in December 2012, though, confirms single-name and index credit swaptions are eligible CVA hedges as long as they don't terminate upon a credit event.

The European bank's head of CVA says it uses short-dated credit swaptions instead of traditional index CDS hedges because the only P&L volatility the bank would face is the loss of the option premium.

"Yes, you end up with some volatility close to the strikes, but typically if they're out-of-the-money options, once in a blue moon they pay off and the rest of the year they just tend to be fairly low volatility and a steady drain on P&L. But they do provide a capital benefit at a reasonable cost, and they're nowhere near as volatile as running a bunch of index hedges," he says.

The head of CVA trading at another European bank says credit swaptions can be an efficient hedging tool for banks, particularly if they have CVA VAR models that are very sensitive to stressed markets and volatile environments.

"If you buy an option today when volatility is cheap, where your VAR model sees a very stressed market, then you have a lot of value. You reduce the loss – your VAR – for a small premium. But if your VAR is not so sensitive, then it may be less efficient," he says.

Another way banks are looking to minimise P&L volatility is by structuring the CVA hedge as a financial guarantee. As these are usually not marked to market, it means a bank can theoretically hedge its regulatory CVA without running up any P&L losses.

"The concept of financial guarantees is obviously not new, and we've looked at how to account for them in various different places over the past five to 10 years, so it's basically going back to the toolbox and looking at how – in the context of VAR on CVA – these instruments could be of use," says a senior CVA trader at a third European bank.

Struggle

So far, however, banks have struggled to make this approach work. One European bank attempted to create a contingent CDS hedge in the form of a financial guarantee, but found it hard to get favourable accounting treatment. In the past, the bank had applied mark-to-market treatment to some guarantees, creating a precedent its auditors refused to overlook. "If you've chosen to do it in a certain way in the past, sometimes you're stuck with that – you can't then pick and choose quite so easily," he says.

Regulators have also been sceptical of guarantees. The CVA head at the first European bank says his institution's national regulator believes CVA hedges should always be marked to market because CVA itself is generally driven by market spreads.

But many believe the idea still has some legs. In the September issue of Risk, Dirk Schubert, a partner at KPMG in Frankfurt, sketched out a guarantee-based product he argued would work as a CVA VAR hedge while also avoiding P&L volatility. The product requires a third party to guarantee the bank's future exposure to its counterparty and stump up daily adjusted collateral to cover day-to-day changes in exposure. To put it another way, variation margin would be paid by the third party, and the guarantee would play the role of initial margin, covering any residual loss at the point of default.

In theory, the products – which Schubert calls cash collateral with contingent financial guarantee (CCCFG) – can act as a hedge of both elements of the regulatory CVA charge without running up accounting losses.

Banks that read the article say they like the idea in theory, but are sceptical it would work in practice. The head of CVA at the second European bank is not certain the guarantee would avoid mark-to-market accounting, which it needs to function as intended.

His bank has explored a contingent CDS structured as a guarantee with insurers and banks. As the standard guarantee structure by design is not collateralised, it was similar to loan-based guarantee products that insurers and banks have been comfortable with for some time. However, when he discussed the accounting treatment internally, the feeling was that while a guarantee on a loan would not be marked to market, a guarantee on a derivative would not qualify for similar treatment.

"The accounting norm tends to be an interpretation of the norm rather than a very clear-cut opinion, and then not everyone may agree. I still have a question mark on this because my experience is that while a guarantee tends not to be marked to market in principle, that treatment can change if the underlying risk is a derivative," he says.

CVA traders also expect it would be tough to find a guarantor. The need for regular posting of cash collateral may put off some funds and insurers, says one trader, who argues banks might be the only institutions willing to write the product – something regulators would not want to see from a systemic risk point of view, and which regulatory capital rules also make extremely difficult.

The senior CVA trader at the third European bank, however, says a number of non-bank entities – hedge funds and sovereign wealth funds, for example – are keen to invest in business that has become capital-intensive for banks, including securitisation, structured products and derivatives counterparty risk. These entities may be willing to warehouse the exposure and back it with collateral, he says, but they may also have higher target returns than real-money players.

A key feature of the product is that if the counterparty defaults, the bank keeps the collateral posted by the third party. The bank then transfers the receivable on its counterparty to the third party in exchange for the difference between the close-out amount and the variation margin already received.

This could be more fiddly than it sounds, the senior CVA trader argues, citing national bankruptcy laws. The transfer process can also be tricky – for instance, the defaulted counterparty may not consent to the transfer of the receivable to the third party, or it could challenge the close-out amount.

Static product

Other issues exist: the head of CVA trading at the first European bank says it would be a relatively static product, and might be difficult to amend as the portfolio of positions changed. "You need the flexibility to be able to change the portfolio you're covering as the clients decide to do new things and change what they've got on with you," he says.

He also says that, again, regulators are less keen to accept structured trades as solutions to CVA hedging problems. "Even though those trades may genuinely provide protection, there have been certain activities and trades in the past - where perhaps there wasn't the same level of risk transfer, and the economics were skewed towards simply getting a capital benefit – that have tarnished the image of the structured transaction and made it slightly more difficult for us to get things accepted by the regulators," he says.

The senior CVA trader at the third European bank says the CCCFG idea holds promise, but he cautions it will take some time to overcome the accompanying obstacles.

"It will take a little bit of time for banks like us and others to bring this to our finance departments, risk departments and so on. One of the last things you want is the appearance that you are trying to circumvent regulation.

We need to be 200% sure that as someone looks at this from outside it will be well understood that it was for genuine economic reasons. All of that requires a lot of work," he says.