Q: HOW FAR DOES AN INSTITUTION NEED TO GO IN TERMS OF IMPLEMENTING A CVA SOLUTION? A: TRAVERS:

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1 Taking a view The evolution of CVA discussed Representatives from SunGard and Navigant Capital Advisors recently came together to discuss current themes related to CVA and counterparty risk in a live webinar, hosted by SCI (view the webinar here). Topics included the implementation of relevant infrastructure, regulatory issues, the changing role of the CVA desk, hedging strategies and the securitisation of CVA and DVA. This Q&A article highlights some of the main talking points from the session. Q: HOW PREPARED ARE BANKS TO DEAL WITH THE CHANGES TO CVA CALCULATION AND THE NEW CAPITAL CHARGES UNDER BASEL 3? A: DAN TRAVERS, PRODUCT MANAGER, RISK SOLUTIONS AT SUNGARD: I'd say the majority of banks feel slightly behind where they would like to be in terms of general preparedness. There's a sense of urgency that firms need a CVA system, or need to improve systems that are already in place. In terms of Basel 3, banks have identified large charges that CVA will be pushing onto them and it's now less than a year until those charges come into effect. We are speaking to a lot of people that have definite budgets to do something in CVA. I would say that probably only the top dozen big banks are really prepared and everyone else is looking to improve what they have got, perhaps except for the really small institutions that are not going to be able to justify the budget to do something in that area. Q: HOW FAR DOES AN INSTITUTION NEED TO GO IN TERMS OF IMPLEMENTING A CVA SOLUTION? A: TRAVERS: The top 100 banks in the world by trading book size will most likely want to do something in terms of CVA simulation methodology. In the medium term, most will be looking at implementing some sensitivities and P&L management, whether it is an active or passive management of that P&L. Below that size, perhaps a calculation on a quarterly P&L basis will be as far as a bank needs to go. Questions still remain as to whether the trading desks' active management of CVA will really catch on in a meaningful way I think this is an important emerging area, but whether it maintains its growth is, as yet, unknown.

2 Q: WHAT ARE THE CHALLENGS INVOLVED IN IMPLEMENTING CVA SYSTEMS? A: TRAVERS: First is the calculation engine actually having an engine that is fast enough to handle all of the derivatives in the required timeframes. Second is the organisational challenge: it's a big challenge in banks to get a mandate clearly defined from the top down. Sometimes the drivers can come from the bottom up, making it difficult to realign the business, charging CVA through on deals and making it part of the business process. Having a clear mandate and the operating model clearly defined is a huge challenge. From an IT point of view there is also a huge data challenge. There's getting trades and market data all fed into the system, then potentially combined with hedge trades. The banks we deal with often find they spend 50% of their time dealing with IT infrastructure. Q: HOW IS THE ROLE AND ACTIVITY OF THE CVA DESK DEVELOPING? A: PAWAN MALIK, PRINCIPAL AT NAVIGANT CAPITAL ADVISORS: I think it varies, depending on the type of institution in question. Tier 1 banks have tended to operate CVA desks for quite some time now, some extending back as far as five to seven years. These banks are tackling subtleties around own credit pricing, the implementation of Basel 2 and 3 and integrating the CVA desk with the funding and treasury business. In mainstream Europe there is a big gap between banks. Some measure CVA in a sophisticated way but don't really do anything about it, then there are others mostly in Northern Europe that have only just started looking at setting up a CVA desk. A CVA desk is like a heart transplant. You essentially have to put in a new business that links into every other business that the firm already has. It is a dramatic risk culture and there are lots of issues around defining mandates that come in. For example, is the CVA desk a profit making entity or a utility function? Does it charge bid offers to other desks that it essentially sells protection to, or does it sell at cost? When there is a default, is there some sort of firstloss that they expect the desk to take to get rid of the moral hazard situation, or do they pay out in full? Do the salesmen get sales credits from both the trading desk as well as the CVA desk? Another topical example is for existing trades: if you are trying to close out an existing swap and it happens to be one where the firm can crystallise a gain on CVA from closing out a swap early, who earns that P&L? Is it the trading desk that first did the trade, or the CVA desk? My experience is that the human capital issues are by far the most difficult. The politics often supersede the need to have a practical CVA system in place. Q: DO MOST CVA DESKS ONLY CONSIDER COUNTERPARTY CREDIT RISK OR DO THEY CONSIDER THE OFFSET OF DVA AS WELL? A: MALIK: I would say that most top tier banks generally do consider DVA, whereas most other banks tend to follow the unilateral method of calculating CVA. DVA is a mysterious and very unpredictable animal because it requires you to mark to market your own liability in a swap. Bizarrely, the value goes up as you get nearer to a default until it hits zero when you finally hit default. The only way you can hedge this is by

3 selling protection on yourself through some sort of proxy trade, so a large amount of your daily P&L volatility comes from your own credit trading risk. It is not something that many of the banks have implemented, one of the reasons being volatility. However, accountants are increasingly telling banks to include DVA. All Tier 1 banks in Europe use it and in the US they have been using own credit and DVA for a number of years. From an IFRS aspect, we would expect this to become more the norm as time progresses. Q: HOW CAN YOU PRICE DVA WHERE NO HEGDE IS AVAILABLE? A: MALIK: There are two parts to this: first, you have to calculate DVA and second you have to ask yourself if you can hedge it. For most banks there is a CDS trading in the market that can be used as a proxy to be able to price it, then in some cases you need to incorporate it with your price with your customer. The second problem is how you find a hedge. Most banks tend to work through the indices. The problem is that it is not particularly efficient. If your bank's spread changes substantially to how the index trades, you will have substantial unexplained P&L volatility on a day to day basis. Switching on a DVA function at a bank is a very big decision. Often you have to get the board's approval because the volatility can be so extreme. TRAVERS: I think certain institutions tread the line between CVA and DVA and manage it as a balancing act between the two camps. For example, it is well known that JPMorgan calculates DVA but has a more flexible attitude in defining what should be considered as its real P&L underlying the numbers that finally come out. Q: HAVE THERE BEEN ANY CONSEQUENCES INTENDED OR UNINTENDED OF CVA HEDGING ON THE WIDER MARKET? A: MALIK: I'm not sure that there have been any unintended consequences, but we have seen a phenomena develop in the sovereign risk market. Until three or four years ago, most institutions would have not charged sales desks for doing derivative trades with sovereigns such as Italy or Spain and in some cases, not even on Greece. As the awareness of the solvency risk of these nations has grown, there has been a surge in the demand for credit protection. Given what has been happening with Greece and the debate around a debt restructuring without a CDS trigger, there has been a big debate over whether CDS hedges that were bought are actually effective. What has surprised me not withstanding this hesitation is that the level of protection continues to be very large. I understand that this is because most banking systems require a hedge and CDS is the only liquid instrument readily available. It remains to be seen what happens if these hedges turn out not to work. Q: WHAT ARE THE RISKS FACING COUNTERPARTIES WITH NO CDS QUOTED? FOR EXAMPLE, SPVS OR COVERED BONDS? MALIK: In practice, CVA desks tend to manage risk that is uncollateralised corporate risk.

4 Where you have margin agreement CSAs with banks, SPVs tend to be managed more as operational risk rather than credit risk or market risk. Your risk is that someone doesn't pay up your collateral. Over the past few years we've seen that even though you expect a trade to be closed out in a certain number of days, the reality is that it may take you a while and within that time the market moves a lot. We've also now seen instances where you would expect set offs to take place that fail to do so. For example, people who bought Lehman US bonds and tried to set them off against swap obligations in the UK found that they couldn't because suddenly the institutions had been separated. Q: HOW CAN CVA BE TRANSFORMED INTO A TRADED RISK? A: MALIK: One of the most common instruments are contingent CDS (CCDS). The idea is that you will find a counterparty that will sell you protection on an interest rate or cross currency swap. This market has not really taken off as much as people would have wanted, although CCDS have traded between banks for as long as the last five or six years. One of the other ways banks have been trying to lay off CVA is by securitising CVA or DVA and selling that risk via the Street or the institutional investor base. There have been instances of this happening in the Tier 1 banks. Q: WHERE WOULD THE SUPPLY OF CCDS COME FROM? A: MALIK: Ideally you would have external investors but initially it would be a dealer driven market. It's a difficult market from a documentation perspective because if you have a default in a typical CDS you would trigger the CDS, deliver the bond and settle in cash. If you have a swap that triggers under EoD and you claim a loss on it, it's very unclear what the loss is: is it what you determine on day one, one that is ultimately decided by the court 18 months later, or is it somewhere in the middle? This is not clear and there are many issues that remain unresolved with regards to CCDS. The fact that a market for it has not developed says a lot. TRAVERS: In some regions we are seeing a surprising amount of activity in CCDS and other types of credit mitigating products. We have seen this particularly in markets where there is a significant amount of low creditworthy counterparties with wrong way risk exposures and with a desire for banks to syndicate or reduce exposures. But this is on a bespoke transaction specific basis. A portfolio of CVA is unlikely to be hedged through CCDS more the matching of a specific transaction with credit mitigating hedges. Q: WHAT DO YOU SEE AS THE NEXT STEPS FOR THE INDUSTRY? A: TRAVERS: There are issues that clearly need resolving. First is regulation: there is a lot of controversy surrounding Basel 3's treatment of CVA in its capital charge for CVA variation. Regulations in place now respect credit hedges but do not respect any market risk hedges that the bank may be actively placing against CVA volatility, which puts those that are actively hedging CVA in a difficult position. Those market hedges will be treated as naked positions as they will not be allowed as hedges in a regulatory sense, therefore they will increase a firm's regulatory capital. I think a

5 lot of people are uncomfortable with that. There is a chance that trade book capital could be reviewed later this year, but the fact that it has already been reviewed once will make it difficult for the regulators to change it again. MALIK: I think there is going to be a much greater awareness and implementation of basic counterparty credit risk frameworks within banks that's going to be partly CVA, partly dealing with the exchanges and central counterparties and potentially integrating the regulatory and treasury functions within that. I think the Tier 1 banks will continue to lead the way in terms of finding ways of reducing P&L volatility that comes from marking to market both the CVA and DVA. The recent trend of finding securitised exits is something that may be worth keeping an eye on. TRAVERS: There are a lot of people piling into the CVA area but I think there will be a distillation of banks those that actively manage it and those that passively manage it. There is some significant investment to be done here so the lower and middle tiers are going to have to make some big decisions on just how much they are going to invest managing CVA. Also the credit risk landscape is changing dramatically and the move towards CCPs will have an effect on reducing CVA. I don't think it will remove it completely, but it may reduce the importance of mitigating it and managing it quite so closely and hence investing so heavily in CVA. Q: WHAT DO CVA MARKET PARTICIPANTS WANT FROM THE REGULATORS? A: TRAVERS: I think they want certainty. Secondly, there are a lot of people that would like market risk hedges included in the charge. MARIO SCHLENER, HEAD OF BUSINESS STRATEGY AND PRODUCT DEVELOPMENT EUROPE AT NAVIGANT CAPITAL ADVISORS: One of the most important topics in the market is how the current regulation is written. Whereas the IFRS perspective is fairly clear, there are still a lot of issues within the Basel framework in terms of how CVA is treated as a risk. There are two different frameworks within which you can think of CVA: is it a market risk that is calculated on a daily basis, or should it be treated from a credit risk driven perspective? Mainstream European banks' business models are generally based on a hold to maturity perspective and so looking at it from that angle, it is more of a credit risk view than a market risk view. Nevertheless the current Basel framework doesn't reflect that in all aspects. For example, the current model on how you calculate your CVA charge on the standard formula and advanced formula on internal models is really not how you would see a CVA risk in its essence. Also, why do you deduct an expected loss in the current default risk capital charge formula? It doesn't give the right reflection of what CVA really is. I would say that the regulators need to decide what they really want to have in place and reflect the risk in terms of the charge that banks need to hold capital for. Do I actually believe this will happen? I don't think so. The regulators have a very clear view and, from the conversations that we have had with them on a broader basis, we do not believe there are a lot of changes coming in especially from a banking book perspective. From a trading

6 book perspective there are still some open questions, such as whether market risk hedges will be eligible in the future. Q: APART FROM REGULATORY ISSUES, ARE THERE ANY OTHER POTENTIAL GLITCHES ON THE HORIZON AND, IF SO, HOW CAN THE INDUSTRY PREPARE? A: TRAVERS: Before a bank actually implements an engine and infrastructure for CVA, I think it is more important for an institution to step back and work out which trades it wants in there, how many sensitivities it wants and how accurate it wants it to be. There are always going to be compromises on how this process within a bank is going to work; as a firm it is worth preparing by working out which compromises you want to make. These decisions will have a big impact on the infrastructure a firm actually puts in place. MALIK: CVA tends to be a very expensive function in times when there is no stress: it only pays out in the tail risk events that happen every so often. We're coming from a situation where we had one big tail risk event in the market a couple of years ago, followed by an amazing amount of liquidity being pumped into the system and a general belief that the major banks would be saved. I think the biggest risk for me is that people are not prepared. Surprisingly, the OTC market is bigger than it was in 2008 and it remains just as opaque, even though the majority of interest rate swaps are being cleared. The clearing houses, CCPs and exchange still face various different issues around clearing multiple products across multiple counterparties and being able to benefit from multilateral products and client netting. In many cases this is still not feasible so many people are still doing what they were always doing, i.e. putting through bilateral trades. If a eurozone event were to take place in the next six to eight months, I am not sure that many people would be ready for it. We may be a little too late in seeing whether CVA works for these institutions in the next crisis but it certainly will give people a lot of food for thought when they come out of it. Similarly, if a big bank were to fail and there was any sort of contagion, I think we may find that a lot of banks would not be ready for it. Published in SCI on 23 rd February 2012