XVA traders have no time to rest on laurels

Markets have calmed, but they may not be out of the woods yet

Managing derivatives valuation adjustments (XVAs) is a complicated task at the best of times. This year, it has been especially tough.

Dealers that entered into uncollateralised foreign exchange and interest rate swaps with corporates saw those trades move deeply in-the-money when central banks cut interest rates in response to the Covid-19 pandemic. At the same time, the credit quality of those clients deteriorated significantly. The combination of rising counterparty risk and soaring uncollateralised exposures caused credit valuation adjustment (CVA) charges to explode.

Across the eight systemically important US banks, the amount of risk-weighted assets (RWAs) attributed to CVA grew by nearly 50% – or $78 billion – between the fourth quarter of 2019 and the first quarter of 2020. 

This counterparty credit risk proved difficult to hedge. The spike in volatility meant credit default swap (CDS) options were “an absolute no-go” in March, according to one XVA trader, while liquidity in single-names was patchy at best.

To make matters worse, the uncollateralised rates and FX trades with corporates were often hedged with collateralised positions at clearing houses. That meant margin calls needed to be funded. The cost of doing so – reflected as funding valuation adjustment (FVA) in the profit and loss statement – jumped as US dollar liquidity was squeezed.

It all added up to billions of dollars in revenue deductions for dealers.

European banks that sought to hedge the interest rate and FX exposures that were pushing accounting CVA and FVA higher faced another headache. Bank capital rules treated these hedges as directional positions, creating an unwanted rise in market RWAs.

Calm, for now

It may be fortunate for XVA traders’ blood pressure that things have calmed down since then. CDS spreads have tightened. And dealer funding costs, measured by asset swap spreads on bank bonds, have also come back down. Spreads on some JP Morgan and Bank of America bonds turned negative recently, indicating demand to buy and cheaper funding costs for those banks, after selling pressure pushed spreads to more than 500 basis points on March 20.    

But XVA desks cannot afford to rest on their laurels. Many are using the downtime to dissect the events of March and April to see what worked and what did not. CVA strategies are being refined to avoid falling into a spiral of worsening credit spreads and disappearing liquidity. European regulators have thus far refused to carve out these hedges from market risk capital requirements and some dealers are overhauling their models to deal with the problem.  

This could turn out to be time well spent. While credit spreads have tightened, XVA traders are not convinced the market is out of the woods just yet. The credit foundations of the market have been badly shaken, says one XVA trader. And while volatility has subsided, he expects to see more defaults over the next six to nine months.

“Neither of those topics are going away, so in some ways we’re still in the middle of the crisis even though it doesn’t feel like it. We still need to have our eyes peeled,” he says.