In the fairground game of whack-a-mole, players are given a mallet and a variety of holes to keep watch over. Small furry critters then begin to spring from the holes, seemingly at random, only to be bashed back inside by the trusty mallet. The aim is to use skill and brute strength to keep the gardener's menace at bay.
The strategy behind the game is not dissimilar to the one that has so far been used by dealers attempting to manage their derivatives valuation adjustments, or XVAs.
Dealers have long used valuation adjustments to account for factors such as counterparty risk – for example, in the form of credit valuation adjustment (CVA). But over the years, banks have gained a deeper understanding of the implicit costs of the derivatives business. And with that expanded knowledge has come an alphabet soup of new XVAs, including funding valuation adjustment (FVA), capital valuation adjustment (KVA), and most recently, margin valuation adjustment (MVA).
As the recognition and management of these adjustments has been formalised, dealers have had to run fast just to keep still. Banks that neglected the impact on their books have often found themselves losing out compared with smarter and more agile rivals. Major global and regional banks have collectively suffered losses of more than $6 billion as a result of FVA, while the losses from KVA are expected to be even bigger. The impact of MVA is also predicted to grow as mandatory margining rules for over-the-counter derivatives come into play and more trades are centrally cleared.
Several years ago, major dealers started to centralise the management and hedging of their derivatives valuation adjustments with dedicated XVA desks. Now, some are launching a joined-up effort to curb their XVAs, under the banner of 'XVA optimisation'. The trend has echoes of banks' drive to reduce their risk-weighted assets in the wake of the financial crisis; given the degree of overlap between the two, many of the techniques and individuals involved are the same. The effect is to make cutting XVAs look less like playing a game of whack-a-mole and more like a deadly round of Mortal Kombat.
The most interesting technique being used as part of this – and the one with the most compelling opportunities attached – is the idea of transferring trades through novations. Dealers say they can pocket millions of dollars by shifting client trades to rival banks with different risk offsets, funding costs, regulatory capital regimes or credit spreads.
Academics gripe at the existence of valuation adjustments for breaking the 'law of one price' – a cherished principle of derivatives pricing. They don't like the idea that different banks might assign different prices to otherwise identical trades, depending on the valuation adjustments they face. But by working together to optimise their XVAs, dealers are finding strength in diversity. They are also releasing considerable sums along the way.