Saturday, March 29, 2014

Using And Misusing XVA Swap Pricing Adjustments

Welcome to the world of swap pricing.  I have never touched swaps in the real world.  Studying their construction during my MBA program was certainly intriguing.  Institutions using swaps in moderation can hedge their exposure to swings in interest rates, commodities, and currencies.  Pricing them realistically means adjusting for the possibility of counterparty defaults.  Adjustments used to be confined to credit valuation adjustments (CVAs) but now encompass a whole family of "XVA" alternatives.  Risk Magazine in 2013 recognized the key role that banks play in using XVAs to price derivatives.

Capital markets quants have choices to make among XVAs.  The original CVA and debit valuation adjustment (DVA) formulations were mirror images of each other.  They balanced a swap's accounting on the mark-to-market exposure statements of both swap counterparties.  Adding a cost adjustment to the DVA builds a funding valuation adjustment (FVA) that provides further clarity on how lending costs for an uncollateralized transaction affect swap exposures.  This very detailed Shearman and Sterling article describes how the legal treatment of these FVAs under Basel capital requirements may differ between US and EU regulatory regimes.

The FVA takes derivative game-playing to a whole new level.  The concept's creators explain it in this Risk Magazine article, "Funding strategies, funding costs."  I don't see the point in adding a second layer of complexity to an already complex process for adjusting derivative prices.  More complex systems are more fragile.  We learned that the hard way in 2008 when investment banks underestimated their own weaknesses.  Adding a replacement valuation adjustment (RVA) to the other layers makes things even more complex, although I can see the usefulness of using it as the only adjustment layer for swaps that have downgrade triggers.

FASB 159 allows corporations to use XVAs to adjust their financial statements.  This takes the debate over smoothing earnings to a whole new level of unreality.  Analysts need to look at MD&A footnotes more closely to see whether systemically important financial institutions (SIFIs) use XVAs to play games with their numbers.  CME Group has an excellent KPMG white paper on principles for managing CVAs.  It is silent on how credit support annexes (CSAs) should net out exposure.  Mark-to-market accounting leaves banks vulnerable to swings in swap valuation that XVAs cannot mitigate.  This makes it imperative for central counterparties (CCPs) displaying derivatives to disclose CSA details.  The CSAs set boundary conditions within which XVAs adjust; disclosure shows the world where mark-to-market accounting will cause a swap to breach its boundary.

Some institutions forget moderation and fall for investment banks' wild pitches.  The i-banks' quants are supposed to use XVAs to think through the market's effects on swap pricing.  They should not use these adjustments to gouge unsophisticated clients out of a few more basis points.  Industry bodies need to pitch in.  The Global Financial Markets Association (GFMA) and the International Capital Market Association (ICMA) should work out some robust guidelines for financial institutions that employ XVAs.  Applying the same guidelines across derivatives markets for interest rates, commodities, and currencies gives the "law of one price" stronger meaning for global investors.  It will also keep bank trading desks within their Basel limits and internal risk appetites.