How can different valuation approaches lead to adverse incentives, misleading analyses and inventive solutions?

Although the various valuation adjustments applied today by the dealers’ community are undoubtedly useful, arguably even necessary from a theoretical perspective, the question of adverse effects and misleading results is as old as the adjustments themselves. Putting aside the original and well-studied argument of the natural hedgers ultimately at risk of stepping away from hedging their genuine economic activity due to the ever increasing costs being passed-on to them by the dealers, a plethora of new adverse incentives appeared alongside the new valuation adjustments being progressively factored in.

Some of the most obvious ones top the list. Shall the xVA desk be considered as a profit- or a cost-centre? The hedging is never perfect and the banks must have a well-defined risk appetite. As an example, an xVA desk might adjust the extent of its CVA hedging by becoming tempted to reap the benefits of the long-term credit losses actually being smaller than those implied by the risk-neutral levels in the market. Another adverse incentive could unexpectedly come internally from the very presence of an xVA desk. Simply the knowledge about the xVA desk taking away the credit and certain market exposures (arguably at a certain price) from the clients-facing desk might wrongly incentivise the sales and trading force to face riskier clients. Another unhealthy practice was due to the DVA – dealers practiced selling protection on their own competitors, not helping decreasing the systemic risks. Luckily that issue, as well as the decoupling between the accounting and the regulatory reportings of the culprit got recently tackled by Basel III.

More recent valuation adjustments, such as the KVA, MVA, Floor VA, etc. all require a decent amount of subjectivity when it comes to their pricing and the behavioural element becomes very present. For example, do we price the capital up to the optional break clause or over the full lifetime? Can we effectively afford breaking the trade from a relationship perspective? Do we expect the client to trade directionally and therefore price in all the adjustments or rather have a regular two-way flow with the bank, therefore drastically reducing the need of pricing those components which depend on the future exposure towards that client? The desire to maintain a good relationship with a given client might lead to a certain bias when assessing the factors above, hypothetically resulting in a misleading analysis and a decision not necessarily rational or beneficial to the bank from a holistic perspective.

All of the elements above, alongside many others, have seen the market participants develop an appetite for smarter and more inventive approaches to their day-to-day trading. A large transaction deemed vanilla only some years ago might warrant an approach similar to a structured product today: regulatory and capital requirements, differing risk appetite between the banks or even a different CSA language between counterparties may lead to the creation of a multilateral and highly structured trade in order to tailor the final capital and economic outcome to the specific needs and constraints. Among the most recent examples of ingenuity, we have for instance witnessed attempts to minimise the bilateral regulatory initial margin impact of a new trade by engineering it in such a way that the natural SIMM approach flaws are being taken advantage of. Arguably, it simply made a rather conservative regulatory margining approach slightly more business-friendly.

In a nutshell, the current context definitely brings new challenges for some (dealers, end-clients) and opportunities for others (third-party providers of bilateral margin optimisation), whilst making the task of explaining the various components of a total VA to the clients ever more challenging.

What are the latest trends within valuation adjustments?

I reckon I won’t surprise anyone by mentioning the various VAs currently present on the shelves of any leading dealer today: KVA, MVA, Floor VA and Spread VA to name just a few. The really interesting part is to which extent are these adjustments being actually applied among the various dealers. There is a differing level of sophistication in the computation itself, quite different underlying assumptions as to the inputs to the cost of capital calculations, the actual management (as opposed to a passive shadow-pricing) of the various components differ from one institution to another. Even the very fact of charging or not the counterparties at all vary in the marketplace. It’s always entertaining to monitor the developments of the pricing practices – no dealer is really eager to make the first move and start charging its clients a new VA. It therefore becomes a question of observing the market, monitoring the emergence of a particular trend in a practice, looking for some pricing “inconsistencies” coming from the other dealers which may indicate that a competitor has started including a new VA into the price it quotes to its clients. Practically speaking, whilst there is a consensus towards the management of the more traditional VAs, such as CVA, FVA, etc., the opinions today still substantially diverge as to how to price or hedge the capital requirements created by a transaction (or if to price or hedge these at all!). The latest challenge was brought-in by the SIMM – the regulatory bilateral initial margin. With a relatively less chaotic start vs. what was expected, the dealers community now came to a point of starting systematically including the SIMM costs into the pricing and passing the impacts on to the clients, during the novations, for instance. As a direct result, we witness a clear trend among the dealers to take part in as many as possible optimisation exercises (both offered by the third-party providers or prepared internally on an ad-hoc basis), demonstrating the substantial resources committed to the task as well as a willingness to reduce the capital and funding requirements.

Could you explain the impact of bilateral margin requirements on CSA contracts?

The SIMM related CSA repapering is a daunting task and the amount of work is colossal, when we consider the regulatory Variation Margin requirements, which kicked in in March 2017. In case we only focus on the regulatory Initial Margin, the general industry readiness was surprisingly high, back in September 2016, where the major dealers started posting the Reg IM to each other. The initial IT and operational hurdles directly related to the SIMM implementation could be considered as being dealt with now, to a large extent. The next challenge is therefore to start preparing the CSA repaperings with those clients which are expected to progressively fall within the regulatory IM scope, starting from September this year. An immediate question is to how to reliably identify those counterparties. A major factor pulling an entity into the SIMM scope being the total currently outstanding uncleared OTC derivatives notional, it is also the one which is very challenging to assess beforehand. From the perspective of the various VAs, the move to a SIMM compliant CSA necessarily brings clarity by removing the “legacy” elements which might have been negotiated in the past, such as large thresholds, MTA, the margining frequency or the non-standard collateral. Unfortunately, that naturally involves an individual ad-hoc discussion with every client involved and an acute resulting question of how to operationally deal with the legacy population of trades – whether moving these under the new CSA or rather keep them in a segregated “old” one? Either choice has its own advantages and drawbacks. Another consideration (among many others) is the operational readiness of the entities getting caught into the SIMM scope. As we’re
progressing towards the September 2020 date, where virtually every financial entity with $8bn of uncleared derivatives outstanding would fall into the SIMM waters, we naturally expect the numbers of CSAs to be repapered to grow every year. Quite intuitively, the “smaller” players are also expected to have less economies of scale during the preparation and the implementation phase, and therefore possibly higher costs associated with the move to the SIMM model as well as purely operational hurdles.

How open are banks to non-standard CSA agreements following the margin requirements?

Here the street is clearly biased towards the standardisation. Although good progress has been made in the migration of the existing CSAs towards the Reg VM compliant ones since the March 2017 kick-off, there are still dozen of thousands of contracts to repaper. Given the sheer volume of documents to process, the approach tends to become a “take-it or leave-it” for non-Tier 1 clients. The industry players impacted by the repaperings just cannot accommodate any individual tweaks and requests in the CSA term-sheets. There were very clear issues emerging from the CSA standardisation for many smaller clients, operationally speaking to begin with. The daily margining example could easily be brought-in. Daily collateral movements could represent a very real hassle for smaller clients, not used to accommodate such requirements. Another example of a more business related reluctance of moving towards the standardised “clean” CSA could be the asset managers. These would quite naturally prefer posting their bonds holding as collateral, for instance, rather than cash. However, non-cash collateral is prohibitively expensive to hold for the dealers, due to its LRD non-nettable status. Moreover, a clean CSA is very obviously free from most of the VAs that would otherwise have been accounted for, reserved and actively managed by the banks. It’s therefore just a very natural conclusion that the banks tend to favour the standardisation in the CSA world.

What would you like to achieve by attending the 7th Annual Derivative Pricing and XVA Forum?

The marcus evans forum is an excellent opportunity to refresh its own ideas about the topic, while making a positive contribution to a panel discussion, led by the major actors in their respective fields. The relatively wide scope of the discussions, the relevance of the topics as well as the broad yet representative attendance make the forum a must-go event in September for me.

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Ahead of the 7th Annual Derivative Pricing and XVA Forum, we spoke with Arthur Alaferdov, CFA, FRM, CAIA, an xVA Trader at UBS, about the latest trends within valuation adjustments.

*All the views and opinions expressed in this interview are solely author’s own and do not express or represent any view or opinion of UBS

Previous Attendees Include:
Bank of America
Bank of England
BNP Paribas
Credit Agricole
Credit Suisse
Deutsche Bank

Deutsche Pfandbriefbank AGHSBC
Lloyds Banking Group
Mitsubishi UFJ
Morgan Stanley


About the Conference:

This marcus evans conference will enable institutions to understand the latest developments within XVA. They will learn how to avoid overcompensation from the overlap between valuation adjustments, and how to best manage and incorporate the latest MVA and KVA calculations into their derivative pricing strategies. They will hear about how CSA agreements are being adapted to best manage and reduce the cost of collateral. Finally, they will address best practices to minimise the effect of the margin requirements and CCP risk on their portfolios. The 7th Annual Derivative Pricing and XVA Forum will take place from the 25th until the 27th of September 2017 in London, United Kingdom.

Copyright © 2017 Marcus Evans. All rights reserved.

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Banco Santander

Bank of England



BNP Paribas


Federal Reserve Bank of New York


Lloyds Banking Group

National Australia Bank







About the speaker:

Since 2016 Arthur has been assuming the adjacent yet distinct roles of an xVA Trader as well as of a Closeout Risk Manager at UBS, ALM division. Prior to his current responsibilities, Arthur tackled the frontier sub-Saharan Africa Eurobonds trading space at Renaissance Capital. His career effectively started on Commerzbank’s Rates Trading desk, where Arthur then seized the opportunity to progress onto a newly created xVA desk there. Arthur holds a French general engineering master degree from ESILV coupled with a Master of Quantitative Finance from University of Technology, Sydney as well as an MSc in Financial Markets from EDHEC, France. Arthur is also a CFA, FRM and CAIA charterholder and particularly keen to discuss the topics of behavioural finance and alternative investments.


What are the latest trends within valuation adjustments?




An interview with Arthur Alaferdov, CFA, FRM, CAIA, an xVA Trader from UBS

Arthur Alaferdov, CFA, FRM, CAIA, an xVA Trader at UBS

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