The CVA-CDS feedback loop

Dealers claim regulators have cooked up a pro-cyclical credit value adjustment (CVA) capital charge that encourages CVA desks to buy credit default swap protection as a hedge. This could push spreads wider, increasing the CVA capital charge and so prompting more protection buying

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The CVA-CDS feedback loop

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The CVA-CDS feedback loop

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Following more than a year of wrangling, European parliamentarians managed to persuade the Polish presidency of the European Union to support tough restrictions on so-called ‘naked’ sovereign credit default swaps (CDSs) – the buying of protection on government debt as an outright short position. The deal, announced on October 18, was hailed as a great victory. Since Germany imposed a unilateral ban on the naked short selling of sovereign CDSs in May 2010, the market had been seen by many as a way for speculators to cash in on European misery. But the real enemy may be closer to home.

“The politicians don’t know anything about how this works,” says the head of one European bank’s sovereign bond desk. “They say they think volatility in the CDS markets is driven by speculation, but the reality is the regulation is causing it.”

That regulation is the charge for credit value adjustment (CVA) under Basel III. It uses CDS spreads to calculate counterparty exposure in derivatives trades, and requires banks to hold capital against that number. It also allows banks to mitigate the capital requirement by buying CDS protection.

The result, dealers say, is pro-cyclical: if the CVA charge increases, they are incentivised to buy CDS protection; if they buy protection, spreads widen and the charge increases further. That dynamic exists today – banks already calculate and hedge CVA exposure using CDSs – but dealers argue the introduction of a specific capital requirement in 2013 will increase demand for protection in a market that is not liquid enough to support it.

The sector could become less liquid still if CDS contracts fail to pay out in the event of a big, voluntary haircut of Greek bonds – as put forward by European leaders in one of their earlier rescue packages. But dealers say CVA hedging will continue regardless, resulting in a regime change in CDS spread levels and volatility.

“The regulation is cyclical and gives too much credit to the depth of the CDS market relative to the size of exposures,” says Guillaume Amblard, global head of fixed-income trading at BNP Paribas in London. “The CVA charge will increase the dynamic rehedging of CVA desks, which will increase the volatility and reduce the liquidity of the market, while exacerbating the cost of funding for sovereigns and corporates.”

Breaking the link

Politicians aren’t completely in the dark about the implications, with some arguing for a change in capital rules to eliminate the reliance on CDS markets. “It is nonsense to tie bank capital safeguard levels to CDSs,” says Pascal Canfin, a French member of the European Parliament and a strong supporter of the ban on naked CDSs, who was responsible for co-ordinating the parliament’s policy on the issue. “The Basel Committee is right in its will to improve the management of CVA risk by banks, but the current solution is not likely to improve financial stability. The effect on sovereign debt markets is unpredictable, but considering the current functioning of the CDS market, these developments are not desirable.”

Stefan Walter, who stepped down from his role as secretary-general of the Basel Committee on October 28, argues that allowing CDS hedges to provide CVA capital relief was the industry’s idea, and says he’s not convinced spreads are being driven – or will be driven – by CVA.

“It’s just not clear to me that the regulation is driving this. Often, broader market responses that would be happening anyway – as a result of people covering themselves – are then imputed on to the regulation,” he says.

People have different opinions on the topic, but here are the facts: derivatives counterparty risk can be mitigated by the two-way posting of collateral under the terms of any credit support annex (CSA) that has been signed, and the CVA charge reflects this. Collateral reduces the amount of money a bank can lose – the exposure – which is one of the key inputs to the capital calculation, along with the level and volatility of CDS spreads (see below: The Basel III CVA charge design). Corporate and sovereign counterparties, however, typically refuse to post collateral, meaning the only way for a bank to reduce the CVA charge on trades with these customers is to buy CDS protection.

What is more, corporates and sovereigns tend to use derivatives for more or less the same reasons: to swap fixed-rate debt into floating, or swap the proceeds of a foreign currency bond into local currency. So, when one trade is in-the-money for a bank, meaning it is exposed to its counterparty, the same will tend to be true across the dealer community. In other words, sovereign and corporate portfolios are not just uncollateralised – they are also directional.

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