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This thesis aims at studying the recent regulatory reforms on deriva-tive markets, namely the central clearing obligation under EMIR and CVA capital charges under Basel III framework. This study shows that the most standardised and liquid classes of OTC derivatives are expected to be cleared via a CCP; the substitution between exchange-traded and OTC derivatives market is likely to take place; and changes in margining practices would transform the counterparty credit risk into liquidity risk. Regarding to the new CVA capital requirement, the examples illustrate market criticism that Basel’s formula ignores market hedges. In addition, it is not always optimal to complete hedge market risks since it would probably cause the CVA volatility to fluc-tuate more.
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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
Thu-Phuong DO (UEVE) Memoire de fin d’etudes 16 October 2014 2 / 33
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.
Thu-Phuong DO (UEVE) Memoire de fin d’etudes 16 October 2014 3 / 33
The recent regulatory reforms on OTC derivatives markets The pre-crisis conditions and objectives of reform
Market conditions (2)
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
Thu-Phuong DO (UEVE) Memoire de fin d’etudes 16 October 2014 4 / 33
The recent regulatory reforms on OTC derivatives markets The pre-crisis conditions and objectives of reform
Market conditions (3)
Condition 3
The Credit Counterparty Risk (CCR) was not sufficiently capturedunder Basel II framework.
The Wrong Way Risk was often ignored in model calibration.
Thu-Phuong DO (UEVE) Memoire de fin d’etudes 16 October 2014 5 / 33
The recent regulatory reforms on OTC derivatives markets The pre-crisis conditions and objectives of reform
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.
Thu-Phuong DO (UEVE) Memoire de fin d’etudes 16 October 2014 6 / 33
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.
Thu-Phuong DO (UEVE) Memoire de fin d’etudes 16 October 2014 7 / 33
The recent regulatory reforms on OTC derivatives markets Key elements of EMIR
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.
Thu-Phuong DO (UEVE) Memoire de fin d’etudes 16 October 2014 8 / 33
The recent regulatory reforms on OTC derivatives markets Key elements of EMIR
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
Thu-Phuong DO (UEVE) Memoire de fin d’etudes 16 October 2014 9 / 33
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).
Thu-Phuong DO (UEVE) Memoire de fin d’etudes 16 October 2014 10 / 33
The recent regulatory reforms on OTC derivatives markets Market changes and issues under debate
Figure: Current state of central clearing on FRA and CDS
Thu-Phuong DO (UEVE) Memoire de fin d’etudes 16 October 2014 11 / 33
The recent regulatory reforms on OTC derivatives markets Market changes and issues under debate
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.
Thu-Phuong DO (UEVE) Memoire de fin d’etudes 16 October 2014 12 / 33
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.
Thu-Phuong DO (UEVE) Memoire de fin d’etudes 16 October 2014 14 / 33
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%.
Thu-Phuong DO (UEVE) Memoire de fin d’etudes 16 October 2014 15 / 33
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.
Thu-Phuong DO (UEVE) Memoire de fin d’etudes 16 October 2014 16 / 33
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.
Thu-Phuong DO (UEVE) Memoire de fin d’etudes 16 October 2014 17 / 33
Basel III and regulatory capital requirement for OTC derivatives Hedging CVA
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.
Thu-Phuong DO (UEVE) Memoire de fin d’etudes 16 October 2014 18 / 33
Basel III and regulatory capital requirement for OTC derivatives Hedging CVA
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.
Thu-Phuong DO (UEVE) Memoire de fin d’etudes 16 October 2014 19 / 33
Basel III and regulatory capital requirement for OTC derivatives Hedging CVA
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.
Thu-Phuong DO (UEVE) Memoire de fin d’etudes 16 October 2014 20 / 33
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
Thu-Phuong DO (UEVE) Memoire de fin d’etudes 16 October 2014 21 / 33
Case study :Trade-off between regulatory capital and earnings Absence of wrong-way risk
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.
Thu-Phuong DO (UEVE) Memoire de fin d’etudes 16 October 2014 22 / 33
Case study :Trade-off between regulatory capital and earnings Absence of wrong-way risk
Thu-Phuong DO (UEVE) Memoire de fin d’etudes 16 October 2014 23 / 33
Case study :Trade-off between regulatory capital and earnings Absence of wrong-way risk
Monte Carlo simulation (2)
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
Thu-Phuong DO (UEVE) Memoire de fin d’etudes 16 October 2014 24 / 33
Case study :Trade-off between regulatory capital and earnings Absence of wrong-way risk
Monte Carlo simulation (3)
Probability of Default
The probability of default is deduced from CDS spreads (usingcdsbootstrap function in Matlab)
Thu-Phuong DO (UEVE) Memoire de fin d’etudes 16 October 2014 25 / 33
Case study :Trade-off between regulatory capital and earnings Absence of wrong-way risk
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.
Thu-Phuong DO (UEVE) Memoire de fin d’etudes 16 October 2014 26 / 33
Case study :Trade-off between regulatory capital and earnings Absence of wrong-way risk
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.
Thu-Phuong DO (UEVE) Memoire de fin d’etudes 16 October 2014 27 / 33
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.
Thu-Phuong DO (UEVE) Memoire de fin d’etudes 16 October 2014 28 / 33
Case study :Trade-off between regulatory capital and earnings Discussion
Discussion (2)
Example of CCCFG between 3 counterparties
Figure: Caption
Thu-Phuong DO (UEVE) Memoire de fin d’etudes 16 October 2014 29 / 33
Case study :Trade-off between regulatory capital and earnings Discussion
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.
Thu-Phuong DO (UEVE) Memoire de fin d’etudes 16 October 2014 30 / 33
THANK YOU FOR YOUR ATTENTION !
Thu-Phuong DO (UEVE) Memoire de fin d’etudes 16 October 2014 31 / 33
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
Thu-Phuong DO (UEVE) Memoire de fin d’etudes 16 October 2014 32 / 33
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
Thu-Phuong DO (UEVE) Memoire de fin d’etudes 16 October 2014 33 / 33