the impacts of recent otc derivatives markets regulatory reform

The impacts of recent OTC derivatives marketsregulatory reform

Thu-Phuong DO

Universite d’Evry Val d’Essonne

Master 2 Gestion des Risques et des Actifs

16 October 2014

Thu-Phuong DO (UEVE) Memoire de fin d’etudes 16 October 2014 1 / 33

Overview

1 The recent regulatory reforms on OTC derivatives marketsThe pre-crisis conditions and objectives of reformKey elements of EMIRMarket changes and issues under debate

2 Basel III and regulatory capital requirement for OTC derivativesRevisions in Basel III regarding OTC derivativesTwo methods for calculating CVA chargesHedging CVA

3 Case study :Trade-off between regulatory capital and earningsAbsence of wrong-way riskDiscussion


The recent regulatory reforms on OTC derivatives markets The pre-crisis conditions and objectives of reform

Market conditions (1)

Condition 1

The OTC derivatives markets outweigh the ETD markets both in terms ofvolume and notional value.




Condition 2

Given the widen gap between Euribor and Eonia, Euribor is no longerconsidered proxy for risk-free rate for the purpose of discounting futurecash flows in derivative pricing. The dual curve discounting practicebecame the new standard in derivative market.

Figure: The evolution of Euribor and Eonia rate from Dec 2005 to Jul 2014




Condition 3

The Credit Counterparty Risk (CCR) was not sufficiently capturedunder Basel II framework.

The Wrong Way Risk was often ignored in model calibration.



Regulatory reforms

In December 2012, the European Commission adopted the technicalstandards for the Regulation on OTC derivatives, centralcounterparties and trade repositories, known as European MarketsInfrastructure Regulation (“EMIR”) ;

Basel III framework was implemented in Europe via CRR/CRD IV,addressing the OTC derivatives market issues by introducing a newcapital requirement for losses resulting from CVA.


The recent regulatory reforms on OTC derivatives markets Key elements of EMIR

Scope of regulation (1)

Product scope : Derivative instruments

“A derivative includes any option, future, swap, forward and otherderivative contract relating to securities, currencies, interest rates,financial indices, commodities, financial contract for differences andcredit default swap”. [MiFID]

The classification of derivatives (either over-the-counter orexchange-traded) is important in determining the complianceobligations.

Question : Are FX Forwards under the scope of regulation of EMIR ?

FX Forwards are viewed as a non-derivative product in the UK but notelsewhere in Europe.

FX market is highly liquid ;

The physical settlement which is common in FX transactions reducesthe credit risk.



Scope of regulation (2)

Market Participants : EU entity or Third country entity

2 categories of market participants :

EU entity, including :

Financial counterparty (FC) ;Non Financial counterparty (NFC) with 2 sub-categories, either NFC+or NFC-.

Third country entity

NFC+ or NFC- : Why is it important ?

The categorisation as NFC+ or NFC- has become important as EMIRclearing and collateral obligations come into effect. For example :

Transaction FC & NFC+ : clearing obligation ;

Transaction FC & NFC- : exempted from clearing obligation.



Clearing Obligation

The two parties enter into two separate contracts with a CCP whichtakes over each party’s positions under original contract. The CCP isnow the counterparty to each of the original parties.3 types of clearing models :

Member clearingClient clearingIndirect clearing


The recent regulatory reforms on OTC derivatives markets Market changes and issues under debate

Most standardised and liquid classes of OTC derivatives are expected to becleared via a CCP

Hull (2010) divided the OTC derivatives transactions into four categoriesto examine the possibility of being cleared :

Plain vanilla derivatives with standard maturity dates ;

Plain vanilla derivatives with non-standard maturity dates ;

Non-standard derivatives for which there are well-established pricingmodels ;

Highly structured deals.

The first two categories have the high chance to be cleared as the variablesfor pricing are observable in the market or easily interpolated (e.g. vanillainterest rate swaps, index CDS, and certain single-name CDS).



Figure: Current state of central clearing on FRA and CDS



Substitution between ETD and OTC : futurisation of swap

The Initial Margin treatment for Futures is much favourable than thatof Swaps (i.e. 1-day VaR vs. 5-day VaR).

The clearing obligation may eliminate the main advantages of OTCderivatives as a low cost and highly tailored product.

e.g. 2 new swap futures products : Eris IMM-dated contracts, CMEDeliverable Future Swap.

Margin requirement : From counterparty credit risk to liquidity risk

The demand for high-quality assets may increase substantially due tothe need for Variable Margin exchanges.

This trend should be considered in the context of other regulatoryframework, i.e. the liquidity ratios under Basel III framework.


Figure: Example of potential variation margin requirement

Basel III and regulatory capital requirement for OTC derivatives Revisions in Basel III regarding OTC derivatives

CCR vs. CVA charge

Counterparty Default CapitalCharge

1 Introduced under Basel IIframework to address thecounterparty default

2 The capital charge is thefixed percentage of RWA,with EAD is determined viaCurrent Exposure method orInternal Model Method(with EEPE approach).

3 Objective : capture thedefault of derivativecontract’s counterparty

CVA Capital Charge

1 Introduced under Basel IIIframework to address thevolatility of fair valueadjustments of derivativecontracts

2 Under Standardised Approach,EAD is estimated from twocomponents : RC and PFE ;Under Advanced approach, theEE is used to calculate the CVA.

3 Objective : capture the volatilitydriven by the market factors thataffect the derivative exposuresand credit spreads changes.


Basel III and regulatory capital requirement for OTC derivatives Two methods for calculating CVA charges

Standardised Approach

Formula

CVA = 2.33 ·√h·√

(∑

i 0.5 · wi · (Mi · EADtotali −Mhedge

i · Bi )− wind ·Mind · Bind)2+∑i 0.75 · w2

i · (Mi · EADtotali −Mhedge

i · Bi )2

Interpretation [Pykhtin (2012)]

Hα = 2.33 ·√∑

i σ2i + 2 · ρ ·

∑i ,j σi · σj − 2 · ρind · σind ·

∑i σi + σ2

ind

CVA : 99% confidence interval of the normally distributed randomvariable Y =

∑i Ni − Nind .

Volatility of the i-th asset : σi = wi · (Mi · EADtotali −Mhedge

i · Bi )

Volatility of index is σind = wind ·Mind · Bind

Assets are assumed to correlate with each other with correlation of25%, and correlate with the index with the correlation of 50%.


Basel III and regulatory capital requirement for OTC derivatives Two methods for calculating CVA charges

Advanced Method

Formula

CVA = LGD ·∑n

i=1

EEti−1+EEti

2 ·max(qc(ti−1)− qc(ti ), 0)

EE(t) : discounted expected exposure at time t

qc(t) = e−sc (t)·tLGD : counterparty survival probability at time t

LGD : How is the Loss Given Default defined ?

“LGDmkt needs to be consistent with the derivation of the hazard rates –and therefore must reflect market expectations of recovery rather thanmitigants or experience specific to the firm”. [BCBS,2012]

Interpretation

The fact that the Advanced Method uses credit spreads and theirvolatilities rather than the predefined regulatory weights makes thismethod more consistent with other VaR methods.


Basel III and regulatory capital requirement for OTC derivatives Hedging CVA

Objectives & Eligible Instruments (1)

Objectives of hedging

Reducing the sensitivity resulting from their own credit spreadfluctuations and those of their counterparties ;

Reducing the Maximum PFE at given confidence level.

The two goals are conflicting and cannot be achieved simultaneously, thusbalancing them is needed.

Eligible hedging instruments

Only CDS is eligible to reduce CVA charges under Basel III :

Single-name CDS

Index CDS

Contingent CDS (CCDS)

The Basel Committee considers only credit spread variations as the sourceof CVA variations.



Objectives & Eligible Instruments (2)

What are the problems associated with the eligibility of hedginginstrument ?

For the majority of counterparties that have no CDS or a contract thattrades infrequently, there are two problems associated with this hedgingeligibility.

Hedging with index CDS on entity whose default probability stronglycorrelates with the underlying exposure

Consequence : This hedging strategy may not always be a good offsetfor the CCR.

A proxy for credit spread has to be used to plug into the Advancedmethod’s CVA formula.

Consequence : The dealers as the result would end up hedging CVA byindex containing the proxy name that may not be well correlated to theunderlying exposure.



Hedging difficulties : Accounting vs. Regulatory CVA

Accounting CVA

1 Under FAS 157 and IFRS 13,CVA has to be recognised asthe adjustment to fair valueof derivative portfolio.

2 Certain large banks haveutilised complicatedmethodology to hedge theCVA volatility by taking intoconsideration every marketrisk factor affecting thederivative future values.

Regulatory CVA

1 Regulatory CVA is calculated byhighly specific formula providedby the Basel Committee withmethod choice conditional onregulatory approval.

2 Only credit spread is capturedas the source for CVA volatilityunder Basel III.

The differences in CVA recognition under Basel III and IFRS result in thedifficulties in designing CVA hedging strategies.



Hedging difficulties : Risk-neutral vs. Real world probability

Risk-neutral probability

1 Used for pricing purposes toensure no-arbitrageopportunities ;

2 Assumption : Investors arerisk neutral ; risk premium isnull.

3 Useful in designingstrategies for hedgingpurpose as it reflects themarket price of instruments.

Real world probability

1 Critical for risk managementpurpose to make inference onthe future value of derivatives ;

2 Investors are actually riskaverse ; risk premium is positive.

3 Useful in CCR assessment andCVA estimation.


Case study :Trade-off between regulatory capital and earnings Absence of wrong-way risk

Example

We consider the example of a portfolio composing of two swaps with twodifferent counterparties (Ccty 1 and Ccty 2) of bank X. The bank decidesto hedge half of the market risk associated with the variations of interestrates of floating leg by entering into an opposite swap with the samecounterparty. We consider hence two identical vanilla swap portfolios.

Portfolio Ccpty Description Notional

1 1 10Y, Pay 1.5% - Receive Euribor 1Y+10bps 1 mil1 1 10Y, Receive 1% - Pay Euribor 1Y+15bps 0.5 mil2 2 10Y, Pay 1.5% - Receive Euribor 1Y+10bps 1 mil2 2 10Y, Receive 1% - Pay Euribor 1Y+15bps 0.5 mil



Monte Carlo simulation (1)

CVA calculation

CVA = (1− R)∑

k e(tk)[P(tk)− P(tk−1)]

R : constant recovery rate (40%)

P(t) : unconditional cumulative probability of default up to time t

e(t) : discounted expected exposure at time t

Hull-White short rates model

drt = (θ(t)− α(t)r(t))dt + σdWt

θ(t) is a function of time determining the average direction in whichthe short rate (r) moves ;

α is the mean reversion rate (α = 0.0425) ;

σ is the annual standard deviation of the short rate (σ = 0.0104)

The market scenarios are generated using HW1F function in Matlab with2 parameters α and σ.




Exposure calculation

The mark-to-markets of swap portfolios are approximated at eachsimulation date using functions hswapapprox andhcomputeMTMValues in Matlab.

LHS : Netting agreement for ccty 1 - No netting agreement for ccty2RHS : Netting agreement for both counterparties




Probability of Default

The probability of default is deduced from CDS spreads (usingcdsbootstrap function in Matlab)



Result (1)

CVA level for swap portfolio

The CVA level actually reduces in the case of netting agreement whichillustrates the market criticism that regulatory CVA calculation ignoresmarket hedges.



Result (2)

CVA volatility

The CVA volatility first diminishes due to the decreasing profile ofDiscounted Expected Exposure and then escalates. The complete markethedge is not always beneficial.


Case study :Trade-off between regulatory capital and earnings Discussion

Discussion (1)

Estimation of probability of default

Sokol (2012) listed out four relevant proxies which can be used to calibratethe probability of default from best to worst :

From CDS spread (if CDS is traded) ;

From bond spread (if bond is traded) ;

From rating transition matrix ;

From comparables (as a last resort).

Cash collateral alongside a contingent financial guarantee - CCCFG

The CCCFG is supposed to bridge the gap and works well under bothregimes of CVA.

The cash collateral reduces the exposure, thus diminishes CVA level.

The contingent element is treated as financial guarantee which is notcarried at fair value according to IFRS.



Discussion (2)

Example of CCCFG between 3 counterparties

Figure: Caption



Discussion (3)

Debt Value Adjustment - DVA

Current status : DVA has been ignored by Basel III framework

We witnessed a considerable fluctuation of banks’ credit spreadsduring the crisis that drove their earnings from loss to profit.

The treatment of DVA along with its potential impacts on regulatorycapital and earnings are an interesting issue to study afterwards.


THANK YOU FOR YOUR ATTENTION !


Bibliography

Bibliography

Basel Committee on Banking Supervision, Basel III : A Global RegulatoryFramework for More Resilient Banks and Banking Systems, December 2010.

Basel Committee on Banking Supervision, “Basel III counterparty credit risk andexposures to central counterparties – Frequently asked questions”, December 2012(Updated of FAQ published in November 2012)

REGLEMENT (UE) No 648/2012 DU PARLEMENT EUROPEEN ET DUCONSEIL du 4 juillet 2012 sur les produits derives de gre a gre, les contrepartiescentrales et les referentiels centraux (Texte presentant de l’interet pour l’EEE)

Elhajjaji O., Subbotin A. (2013), CVA with Wrong Way Risk : Sensitivities,Volatility and Hedging, Working paper, October 7th 2013

Alexander Sokol, Numerix/CompatibL, PRIMIA Global Risk Conference 2012, NYC

Pykhtin M. (2012), Model foundations of the Basel III standardised CVA charge,Risk magazine, July 2012


Bibliography

Bibliography

Pykhtin M., Rosen D. (2010), Pricing Counterparty Risk at the Trade Level andCVA Allocations, Finance and Economics Discussion Series, October 2010

Hull J., White A. (2012), CVA and Wrong Way Risk, Financial Analysts Journal,Vol 68, No.5 (Sept/Oct 2012), p.58-69

Hull J. (2010), OTC derivatives and central clearing : Can all transactions becleared ?, Financial Stability Review, 2010, issue 14, p.71-78

Gregory, J. (2012), “Counterparty Credit Risk and Credit Value Adjustment : AContinuing Challenge for Global Financial Markets”,Wiley, Second Edition

Source data Euribor, Eonia, CDS, etc from Bloomberg

www.mathworks.fr, www.fincad.com


www.mathworks.fr

www.fincad.com

the impacts of recent otc derivatives markets regulatory reform

Economy & Finance

otc derivatives market

recent regulatory reforms

otc derivativesrevisions

ueve memoire

fin detudes

otc derivativestwo methods

derivative market

regulatory capital requirement