CVA desks arm themselves for the next crisis

March’s volatility forces dealers to fine-tune hedging strategies

NB Illustration/Ben Hasler

April is said to be the cruellest month. But for one European bank’s credit valuation adjustment desk, the pain came a month earlier.

The bank had entered into a series of interest rate swaps and foreign exchange derivatives with a group of South American oil companies. The trades moved firmly in the bank’s favour after central banks cut policy rates in March, but the subsequent collapse in oil prices caused the credit risk of its counterparties to spike.

The result was a double whammy. As its positions moved more in-the-money, the bank's counterparty exposures to the oil companies increased. Then the oil price crashed and the credit default swap (CDS) spreads of the oil companies blew out. This forced the bank to make deductions to the value of its derivatives in its earnings statement, resulting in so-called credit valuation adjustment losses. The amount of capital the bank had to hold against future CVA risk also rose significantly.

As the bank did not trade oil derivatives with the clients, it did not include them as a sensitivity in its CVA calculations.

“Therefore, a few months ago we started working on a new way to model our exposure so that, despite us not having any products in oil, the portfolio recognises that we have an exposure to oil. As a result, we have introduced a factorial model based on different market risk factors into our portfolio – with one of those market risk factors being oil,” says the CVA desk head.

The bank is now exploring whether to trade oil options as a hedge for the impact on CVA from further shifts in the oil price. It’s also looking to trade knock-in FX options in the currency of the counterparty as a cheap, indirect hedge against the double hit.

This is one example of the conversations taking place at dealers about how CVA desks should react to a Covid-driven crisis that led to billions in losses from derivative valuation adjustments (XVAs) for major investment banks in the first quarter.

At Spain’s BBVA, the hedging strategy for CVA used to focus on limiting exposure to losses stemming from broad movements in the economy, or so-called macro hedging. Now it has a greater emphasis on single-name CDS trading in companies in particularly stressed sectors.

Julien Second, head of XVA trading at RBC Capital Markets, is less explicit about what the dealer intends to change, but says it’s important to dissect the events of March to see what worked and what needs to be improved.

“You can’t become complacent and think you know what the next crisis will look like and therefore exactly what hedges you’ll need to pile on,” he says.

CVA traders at other banks say they are unlikely to make drastic changes to their hedging policies. They are content to wait for liquidity to return to their credit derivative instrument of choice.

But patchy trading in some single-name credit derivatives means spreads can quickly spiral out of control. As CVA is partly based on a counterparty’s credit default swap spreads, banks can be sucked into a vortex of widening CDS prices amid a stampede for hedges.

Living on the hedge

The custodians of capital standards in Basel may not have envisaged this outcome when they crafted the latest version of their regulatory framework.

Basel III requires banks to hold capital against future variations in counterparty credit risk, known as the CVA capital charge. This charge can only be mitigated using credit derivatives, typically single-name and index credit default swaps, as well as CDS options.

With single-name CDS volumes on the slide in recent years, indexes have been a tool of choice for many CVA desks.

Single-name CDS had a global notional value of $18.9 trillion in the first half of 2010, according to the Bank for International Settlements. By the second half of 2019, this figure had dwindled to $3.5 trillion.

CDS index volumes have also declined in liquidity, but at a less rapid pace. At $4.1 trillion in notional value, they remain a more liquid hedging instrument for banks.

So when corporate credit risk climbed at the onset of the Covid crisis, CDS spreads widened. This reflected a hike in demand for the instruments but also a lack of liquidity.

Average bid/offer spreads rocketed from 9 basis points during the first two months of the year to a peak of 140bp during April, for five of the most widely traded single-name CDS.

 

 

Options on index CDS have risen in popularity as a way of minimising the profit-and-loss impact of hedging the CVA capital charge. But liquidity quickly dried up in these instruments too after the Covid-induced volatility set in (see box: CDS index options “no-go” in March).

In response, CVA desks reached for the only liquid product left in March: CDS indexes. Data from the DTCC’s Trade Information Warehouse suggests indexes were the hedge of choice in March. In the three months to March 19, the number of average daily trades of on-the-run US and European indexes more than doubled compared to the previous period, suggesting heavy use as an emergency hedge during the crisis. Trade volumes then fell back by 30% during the following period.

The difference between the CDS index spreads and the spreads of their constituent single names also widened in March, indicating a big surge of index buying that pushed the two apart. The so-called skew level was at around -20 for the CDX.NA.HY index at the start of the year, but jumped up to above +40 by March 9, according to data from IHS Markit.

There was another reason for banks to switch to indexes. Dramatic moves in the market meant correlations between the spreads of single-name swaps were close to one. Hence, indexes became a good way of capturing directional moves across a whole portfolio.

 

Max Maier, head of front and XVA trading at LBBW, says the German bank came into the crisis period with a micro hedging strategy focusing on single names. But the desk pivoted to an index-based strategy to help capture the directional moves of the market.

“In March it became clear that focusing on individual risks wasn’t an option in this market environment given the very fast movement of the underlying risk factors. So we instead began focusing on risks within a more macro portfolio lens,” he says.

Other dealers preferred to stick to single-name swaps rather than using indexes as a proxy for wider exposure. Karin Bergeron, head of XVA trading at Scotiabank, says certain sectors affected badly by Covid have diverged from the rest of the index. As a result, the bank has opted for single-name CDS in recent months.

“There were times in which the use of proxies has been essential to manage risk when the ‘perfect’ hedge was unavailable or overly expensive. However, during the crisis we have been more willing to pay a bit more and get the ‘perfect’ hedge rather than using a proxy, as correlations have not been performing as usual and proxy hedging in many cases has proven to be more dangerous than before,” she says.

Not all companies have an equivalent credit default swap. For these names, dealers had to get creative. One CVA desk chose to hedge the underlying instrument for a counterparty that lacked a tradable CDS. In doing so, the bank hoped to “freeze our exposure to the counterparty and limit a bit of the potential default loss”, says a senior treasurer at the bank.

Higher still and higher

As credit risk swirled, so did market risk. Movements on existing hedges caused the overall exposure for CVA desks to increase.

Many banks run a trading book position where they are net receivers of fixed interest rates from corporate clients. When interest rates decrease – as they did in March due to central bank cuts – it meant banks were more in-the-money against corporates and other clients. So dealers’ overall CVA exposure climbed.

“The drop in value of the euro against the dollar, plus the drop in interest rates within both the euro and dollar, has massively increased our CVA,” says the head of CVA at the European bank.

Dealers tend to hedge this rise in exposure by trading in the interest rate and FX derivatives market. These hedges don’t offset the CVA capital charge, but they do help reduce the impact of accounting CVA in the P&L statement, so it’s considered a prudent exercise. Nevertheless, the speed of the market moves in March caught many off-guard.

“While we entered the crisis with relatively powerful hedges in place, we suffered because of the extreme violence of market moves,” says the CVA head.

LBBW’s Maier says it forced them to be much more active than usual when looking to rebalance their market risk hedges in the interest rate and FX derivatives market.

“Pre-Covid, banks adjusted their hedges one or two times a day, but during Covid that more than doubled. In particular, anticipating how all the simultaneous market movements are affecting your risk sensitivities and risk factors became very crucial for CVA hedging,” he says.

Doom loop

Under Basel capital rules, hedges against counterparty credit risk can be used to reduce a bank’s CVA capital requirements, but the same does not apply to hedges against the market risk of underlying instruments. This meant more credit derivatives hedging was needed to mitigate the soaring capital cost.

Across the eight systemically important US banks, the amount of risk-weighted assets attributed to CVA grew by nearly 50% between the fourth quarter of 2019 and the first quarter of 2020. In dollar terms, this was a rise of $78 billion.

 

As March turned into April, it became clearer that some names and sectors would be more affected by the pandemic than others. Consequently, some single-name swaps started to move out of step with the CDS index hedges.

This helped spur more use of single-name CDS trading. According to DTCC data, the average daily trading numbers for the top 1,000 counterparties, excluding sovereigns, was flat in the six months to March 19, but rose nearly 40% in the following three months, at the same time indexes were falling back.

Given the lack of liquidity in some of the single names – DTCC data shows nearly a third of single-name CDS had zero average daily trades in the three months to December 19 – an increase in trading can easily move the credit spreads.

Traders say that when single-name trading picked up, some swaps began to suffer from a negative feedback loop, whereby the increased use of CDS caused credit spreads to widen. And as CVA calculations are based on CDS spreads, this in turn caused banks’ CVA exposures to increase. As a result, banks had to use more CDS to hedge their exposures, causing CDS spreads to widen further.

“It’s a doom loop that we struggled to exit and is the reason why most of the CVA desks across the Street suffered losses in March and April,” says the head of CVA at the European bank. He adds that their exposure to one particular name multiplied by seven due to the exacerbated credit position the doom loop created for their portfolio.

The doom loop can affect index positions too, but the effect is less pronounced because of deeper liquidity in the instruments, experts say.

The head of CVA at the European bank says the normal response to such circumstances is to find a compromise between fully hedging a credit position and not doing so, to minimise the increase in CVA exposure created by the doom loop. But he adds this wasn’t possible for the bank during March given the potential losses they were facing. Instead, they had to continue hedging with CDS.

“This negative feedback loop is definitely not a comfortable position to be in and probably became the core risk of our CVA book,” he says.

Daniel Cremades, global head of CVA and FVA trading at BBVA, says CVA desks tend to hold very similar positions to each other, causing a scramble in the market for particular names and indexes. This further exacerbated the doom loop.

“Normally, the first lesson of trading is that you should buy cheap and sell expensive, but in a scenario like this you have to buy expensive because it could get even more expensive down the line. So one has to trade like that to a certain extent as otherwise it can mean a big loss for the book,” he says.

Beware the slippage

Four months on from March, CVA desks have been able to pause for breath and consider any lessons to be learnt from the volatility.

The European bank’s CVA head says the desk has been addressing slippage between illiquid counterparties and CDS index hedges. 

If a bank is using a CDS index hedge for the CVA capital charge, Basel III requires any basis between the counterparty’s spread and the index hedges to be reflected in the value-at-risk calculation that generates the capital requirement. So the more dispersion between the counterparty spreads and the index, the higher the capital charge.

“In March some names widened more than would have been expected from their sector or geography, while other names widened less than would have been expected, so we were hit to some extent by the dispersion between the two,” he says. 

The bank is now exploring a fix that maps illiquid credit names on to liquid indexes, to boost the efficiency of the index hedge.

Meanwhile, BBVA is looking to move back into options where possible. But Cremades says the bank will be paying greater attention to single-name CDS for the time being given the current dispersion between names in the index.

A CVA head at a second European bank says they are also looking to return to options-based credit hedging strategies now that markets are calmer.

“We’re not quite back to how things were in January but volatility is certainly a lot lower and we’ve seen liquidity returning in the form of counterparties being more willing to sell options. That’s been great as we’ve been replacing some of our index CDS positions,” he says.

RBC’s Second sees a silver lining in March’s cloud as the period can now serve as a stress scenario for the bank’s hedging strategies, after a prolonged period of low volatility.

“There aren’t many crisis calibration periods from the last 10 years that you can input into your stress-testing, which makes it difficult to test the effectiveness of your hedging strategy. When markets are quiet everything works. The only time you find out whether your hedging strategies work is during a time of crisis, so Covid has given us a golden opportunity to reassess everything and test what did work and what needs to be improved,” he says.

CDS index options “no-go” in March

Options on credit default swap indexes have long been used as a hedge for the Basel III CVA value-at-risk charge. The 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 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 on a credit event.

Options have been seen as a way to minimise the impact of CVA hedging on bank earnings. This occurs due to a mismatch between the current CVA VAR rules and accounting CVA, which measures the point-in-time level of CVA and appears in the profit-and-loss statement.

CDS hedges can mitigate CVA VAR from a capital perspective, but from an accounting viewpoint they are directional positions that generate gains and losses, and lead to P&L volatility. The issue attracted attention when Deutsche Bank generated millions of euros of losses due to the slippage in 2012, and led to more widespread use of options as an alternative hedge.

Options are useful because, unlike a single-name or index CDS hedge, the P&L volatility is limited to the premium paid on the option. Daniel Cremades at BBVA says the bank would also use options strategies to cheapen the cost of hedging – for instance, buying an out-of-the-money option and selling an even more out-of-the-money option.

But when Covid volatility hit in March, spreads on CDS index options widened to the point where banks were no longer able to use the strategies. Spreads stood at a low of 0.343 basis points on February 18, but reached a peak of 7.593 basis points by March 31. At the time of writing, the spread stood at 0.742 basis points.

 

“Under normal circumstances we hedge using credit options but in March the market started moving all over the place and the volatility of options skyrocketed so it wasn’t really possible to rely on old strategies,” says BBVA’s Cremades.

“There was no way to trade options to protect yourself in March, they were an absolute no-go,” he adds.

The head of CVA at the second European bank says they also had to ditch their options-based strategy: “The market dried up during the crisis, deteriorating to the point where bid/offers and pricing became too far out for us to consider credit swaptions as a reasonable hedge,” he says.

That however meant the bank lost the P&L volatility-dampening benefits that swaptions can bring: “That was unfortunate but given the market there was no way around it. We needed to have the hedges on and the only way we could do that was through the CDS index rather than through swaptions,” the CVA head says.

Editing by Alex Krohn