Corporates use XVA caps to limit unwind charges

Veolia caps CVA and FVA unwind costs in trades with 10 banks

Veolia executed its first FVA and CVA cap in 2012

Big corporates have found a new way to reduce the cost of trading derivatives on an uncollateralised basis: pay dealers upfront for a cap on the charges that can accompany an unwind. For the buyer, the cap replaces an unknown cost with a known one, but it further increases the complexity of the business for dealers, which claim the option is impossible to hedge.

Paris-based water, energy and waste giant Veolia is the only company known to have executed the caps, but it claims to have done so with 10 dealers in all. Banks say a growing number of other clients are doing the same.

"It offers comfort and visibility regarding the costs because it protects you from paying so much during unwinds, which is relevant as we are a corporate that manages its debt on a dynamic basis," says Damien Vancraeyneste, head of dealing room and structured finance at Veolia.

Capped trade savings

Over the past two years, Veolia has unwound more than €1 billion of interest rate trades – some capped, some not – and estimates savings on its capped trades will amount to millions of euros once exercised. It executed the first cap in 2012.

Risk spoke to three banks that say they will – selectively – sell the caps.

It offers comfort and visibility regarding the costs because it protects you from paying so much during unwinds

"It is not something we are offering on a mainstream basis. It's more of a bespoke feature we might provide to specific clients," says a trader on the XVA desk of a large European bank.

Protect against unpredictable costs

The caps protect against hard-to-predict costs arising from credit and funding valuation adjustments (CVA and FVA). The adjustments, which are being priced in a more systematic way by dealers in the post-crisis years, have been a source of frustration to bank clients, because they are often trade and dealer specific, making pricing opaque. It can be a particular bone of contention during unwinds.

Most corporates trade without any collateral agreement in place, because they want to avoid the resulting margin requirements, but dealers will often hedge these trades under the terms of a two-way collateral agreement.

In such cases, if an uncollateralised trade has a positive mark-to-market for a corporate, the bank should be receiving collateral on the associated hedge, but would not have to on-post it to the corporate, creating a funding benefit. Unwinding the swap would therefore increase the net funding requirement for the remaining portfolio, and also create additional counterparty exposure for the dealer, because the hedge would no longer have an offset.

Reducing unwind payouts

These CVA and FVA charges are hard for a corporate to anticipate and can materially reduce the payout on an unwind. Veolia's first cap, sold by Societe Generale, came after the company was hit with surprisingly high costs when unwinding a large interest rate swap portfolio with a big, positive mark-to-market value, says Vancraeyneste.

In Veolia's case, the cap limits the CVA and FVA unwind charges to a proportion of the per-basis-point sensitivity of the trade. The company has developed its own methodology to calculate what it should be paying for a given level of cap.

Other companies are said to be getting the same kind of protection now. While the cost of the option will vary, dealers estimate it will typically add a few basis points to the upfront cost of a trade.

"Some clients definitely want it – it gives them more comfort with their auditors, as well as more visibility about any future costs when unwinding these trades," says the head of the CVA desk at a large European bank.

Difficult to hedge

For dealers, the option is a complex one to price and risk manage.

"This option is extremely difficult to hedge. Let's say the client wants to unwind a 10-year swap within the next two to three years; we will have to model credit volatility and funding volatility to take into account these optional payouts at the time of unwind, and the client does not specify when he wants to unwind it. It is like an American option. The credit volatility and funding volatility are not hedgeable," says the CVA desk head.

To limit its exposure, the European bank only offers caps to its platinum clients, and only for short- and medium-term swaps where the potential future exposure is relatively limited.

"If you have to sit on some risk you can't hedge, the bank is not happy by definition, but the trades keep the clients happy," says the CVA desk head.