Challenges facing the South African derivatives market kpmg.co.za
1 Challenges facing the South African derivatives market The unrelenting waves of regulatory reforms that have followed in the wake of the 2008-09 crises are creating tectonic shifts across the derivatives landscape. The South African derivatives market is far from immune. Amoung the swath of regulations are Basel III and Solvency Assessment and Management Framework, while as a member of the G20 South Africa will also start to address OTC derivatives reform through the framework of the Financial Markets Act. At the intersection of these regulatory reforms is the desire for greater transparency and more secure derivatives trading, to buffer and safeguard financial markets against another meltdown. These reforms have, however, introduced a significant degree of complexity. They will change the way that derivatives are priced, traded and reported. With so many of the operational details still in evolution, there is much uncertainty among market participants. Beyond the banks, a broad range of market participants will feel the impact: from corporates hedging their FX and interest rate exposures, to insurance companies hedging their long-dated liabilities, and from hedge funds and asset managers executing a variety of strategies, to pension funds focusing on long-dated funds. Business models, operations and infrastructure will have to adapt and evolve, balancing the imminent and urgent against the longer-term strategy and available resources. The unintended consequences introduced by the new paradigm will be revealed in time. For now, KPMG sought to unlock the perspectives of South African derivatives market participants, gaining insight through a survey and discussions. We would like to thank survey respondents for participating in this survey. We appreciate your time and effort and would like to assure you that all the information that has been provided is treated with the utmost confidentiality. To this end, the names of survey participants are not disclosed and results have been anonymised. To preserve anonymity, we have presented qualitative feedback, as revealing explicit quantitative statistics was deemed potentially compromising to respondents due to sample size.
2 Financial crises tend to exacerbate counterparty credit risk. When the tide goes out... On 15 September 2008, Lehman Brothers filed its bankruptcy petition. The default exposed the lack of transparency around the credit worthiness of derivative market players, the exposure size not to mention who was ultimately exposed, and spotlighted issues relating to collateral management. More than five years on, a number of the changes facing the world of listed and over-the-counter (OTC) derivatives relate to managing and mitigating counterparty credit risk. Counterparty credit risk is the risk that the counterparty to a non-exchange-traded contract defaults prior to expiration. It differs from conventional credit risk in the fact that (1) exposure at the time of default is uncertain as it depends on future market dynamics and (2) the risk is generally bilateral, as either party may end up owing money to the other. Financial crises tend to exacerbate counterparty credit risk. Not only do counterparty default probabilities increase, but so do derivatives exposures. In addition, the credit quality of financial institutions becomes highly correlated in times of crisis. Given the predominance of inter-bank trade, the resulting inter-dependencies can pose considerable risk to the stability of the entire global financial system. 1 Basel III Change Introduction of a capital charge based on Expected Positive Exposure using a stress calibration 2 Introduction of CVA VaR Capital Charge 3 4 Incentives to encourage use of Central Counterparties (CCPs) for standardised derivatives Enhanced requirements for capturing Wrong Way Risk (WWR) 5 Enhanced collateral management requirements 6 Enhanced requirements for counterparty risk stress testing 7 Enhanced requirements for Model Validation 8 Asset Correlation Multiplier of 1.25X Description Applies to banks using an Internal Model method (IMM) Applies to all banks formula-based and models-based approach Derivatives cleared via CCPs will attract a low Risk Weight proposed at 2%. They will not be subject to the CVA VaR Capital Charge. WWR should be captured via stress testing, scenario analysis and reporting. Specific WWR should be capitalised. Increased margin period of risk. Revised shortcut method for modelling Effective Expected Positive Exposure (EEPE). Required to include stress testing of key market factors, apply multi-factor stresses, and assess material-basis risks quarterly. Firms must have a regular backtesting programme, independent validation and review Applies to firms with total assets of more than US$100 million, and unregulated entities
3 The CVA charge will capture potential mark-to-market changes related to fluctuations in the credit quality of a bank s counterparties. CVA is the difference between the risk-free value of the derivative and the true value, taking into account the expected loss due to counterparty defaults. CVA Credit Valuation Adjustment, the conceptually simple, yet operationally challenging, metric that emerged as an accounting stipulation in 2000, is attracting attention and debate as a result of the inclusion of a CVA VaR capital requirement in Basel III. The decision to include an explicit capital requirement stems from the observation by the Bank of International Settlements (BIS) that nearly two thirds of losses that banks suffered during the credit crisis emanated from CVA volatility, whereas only one third could be directly attributed to actual default. CVA will capture potential markto-market changes related to fluctuations in the credit quality of a bank s counterparties. South Africa has been awarded a stay of execution the SARB directive D3/2012 permits a zero risk weight for CVA on ZAR based derivatives and derivatives with local counterparties for 2013, pending the finalisation of a centralised counterparty for over the counter (OTC) derivatives in South Africa. However, banks agree that it is not just about meeting a regulatory requirement the rationale behind quantifying and managing CVA is prudent risk management practice. While the degree of implementation varies, the end game is a centralised group, the CVA desk, whether this involves leveraging vendor solutions or offshore capabilities. Where vendor models are used, development flexibility and open structure have been key requirements.
4 Graphic illustrating how a typical CVA desk operates Firm Service Line CVA Trading Desk Trading Desk CVA on market trade CVA Team Reserve: P&L Compensation against losses on counterparty default Market Counterparty Counterparty Some of the key concerns when setting up the CVA desk: Which transactions are managed by the desk? What is the CVA desk mandate? Does it operate as a profit centre?
5 Given the degree of counterparty concentration, as well as the lack of CDS contract coverage, respondents have generally adopted a pragmatic approach to managing CVA. Banks have tended to focus initially on those counterparties and transactions which are the largest drivers of the CVA charge. Considering the relative size of the interest rate and FX derivatives markets, it is not surprising that implementation efforts are focused on these asset classes. Addressing whether CVA charges are uniformly included in pricing, buy-side survey respondents have observed pricing differences that they attribute to the introduction of CVA in pricing, sourced across all banks operating in the South African market. Feedback suggests that CVA may, however, be excluded for particular transactions for relationship reasons, in instances where there is cross-subsidisation from other areas of the business, or where banks deem that collateral agreements are sufficiently robust. In the majority of cases, CVA desk mandates are still in evolution. Among the considerations in this regard was whether the CVA desk should operate as a profit centre, with respondents expressing concern that this could perversely incentivise steeper CVA charges. It was noted that even some of the sophisticated offshore banks employed a zero budget mandate. Respondents agree that it is important to ensure that pricing methodology is internally transparent and that trades should not be allowed to be rejected without strong justifications. Active management of CVA takes place within the front office, and the calculation and monitoring of CVA VaR takes places within the market risk function. One of the ways that banks can reduce the CVA capital charge is by entering into bilateral Credit Support Annex (CSA) agreements with their clients, which require the client to post and receive collateral. Some of the larger buy-side institutions report being approached by banks seeking to educate on the pricing impact of various collateral arrangements, such as adjusted thresholds (A collateral threshold is the unsecured credit exposure limit that both counterparties will accept before they request collateral), minimum transfer amounts (MTAs) and amended CSA terms. In an effort to achieve improved pricing, a number of the buy-side respondents expressed a willingness to amend existing CSAs, or have already done so. Corporate clients have tended to be reluctant to enter into bilateral CSAs due to the administrative burden of servicing collateral as well as the potentially detrimental cash flow implications diverting cash from operations at a time when the corporate may need it most. Mandatory break clauses have been identified as a potentially more palatable solution. A mandatory break clause breaks the deal after a specified period, effectively shortening the life of the credit exposure. Anecdotally, the formalisation of CVA pricing has resulted in behavioural changes among front office staff including increased awareness of counterparty risk predeal and increased focus on risk mitigants when originating deals. The CVA calculation is a function of the derivative exposure, PD and recovery rate. The exposure variable of the CVA calculation is generally estimated through Monte Carlo simulation of underlying risk factors. Future exposures for complex products may be estimated by using more vanilla products as proxies, or by using the current or a scenariobased mark-to-market (MtM). While efforts are made to source probability of default and recovery rate information from current CDS markets, the low liquidity and market breadth of the South African CDS market forces respondents to adopt some form of mapping approach. In the absence of consensus on best practice, default probability derivation was discussed more generally. Suggestions included mapping internal counterparty ratings to historical and/or market-based default and recovery information, introducing bond proxies, using an observable index to extrapolate beyond observable tenors, and the development of proprietary industry or geographical proxies in conjunction with a spread to cater for idiosyncratic risk.
6 The low liquidity and market breadth of the South African CDS market forces respondents to adopt some form of mapping approach. Whenever the CDS spread of the counterparty is available, this must be used. Whenever such a CDS spread is not available, the bank must use a proxy spread that is appropriate based on the rating, industry and region of the counterparty. Paragraph 98 of Basel III The worst-case scenario for counterparty credit risk occurs when the exposure to the counterparty is adversely correlated with the credit quality of the counterparty. In its general form, wrong-way risk arises where a derivative s exposure and counterparty s creditworthiness are both impacted by macroeconomic factors. Specific wrong-way risk arises when there is an adverse correlation between the credit worthiness of the counterparty and the transaction-specific variables. Wrong-way risk can introduce negative gamma complications to CVA hedging. Respondents identify specific wrong-way risk transactions at trade initiation as part of the new product process, addressing it by taking into consideration the high correlation between the default event and exposure to the counterparty when calculating the potential exposure and security margin requirements on these transactions. Respondents monitor general wrong-way risk through scenario analysis. Basel III regulations require banks to incorporate wrong-way risk into forecasted exposures by calculating effective expected positive exposures over a stressed period. The European Bank Authority s June 2012 Basel III monitoring exercise reveals that the introduction of CVA capital charges resulted in an average Risk Weighted Assets (RWA) increase of 7.8% for Group 1 and of 3.8% for Group 2 European banks. 1 Specific wrong-way risk may arise in transactions with certain structural features such as the collateralisation of a loan with the borrower or a related party s shares. General wrong-way risk may arise from situations where both the credit quality of the counterparty and the value of the derivative are strongly related to a macroeconomic variable. For instance, the underlying of the derivative and the counterparty may be in the same industry, or the same geographical region. As the CVA VaR charge in Basel III can have a significant impact on regulatory capital requirements, the extent to which banks are able to effectively hedge CVA is viewed as a key source of competitive advantage. Consensus is for the measurement and management of market risk and credit risk sensitivities of CVA desk portfolios. When it comes to hedging the CVA exposure, South African market realities pose a serious challenge. Not only are there no CDS contracts on the vast majority of derivatives counterparties, but even where they do exist, low liquidity and limited tenor buckets are constraints. The exemption of European Banks from CVA capital charges on trades with corporates, sovereigns and pension funds has attracted interest. The European exemption within the fourth Capital Requirements Directive (CRD IV) was based on the argument that (1) the CVA capital charge is difficult to calculate given that so few of the European corporates have a liquid CDS contract, (2) the relative importance of corporates to the total counterparty pool, and (3) that it was punitive towards institutions that are unable to shift to exchange-traded products that do not attract CVA charges. Survey respondents believe comparable arguments hold true in South Africa. In addition, if the exemption becomes more broadly accepted, maintaining the charge for these counterparties could result in regulatory arbitrage, prejudicing the local banking market. 1 (Group 1 banks are defined as those with Tier 1 capital in excess of 3 billon and are internationally active. All other banks are categorised as Group 2 banks) (http://www.eba.europa.eu/cebs/media/publications/other%20publications/qis/isg-basel-iii-monitoring-exercise---public-report--final-.pdf)
7 Respondents are concerned that, if the cost of executing OTC transactions becomes too prohibitive for corporate clients in particular, that this could result in a significant shift in the industry. Could increased demand from banks for singlename credit encourage supply? Respondents argue that muted demand from other secondary market players, such as asset managers and corporates, could prove a limiting factor. In particular, the finance regulatory framework does not incentivise corporates to trade in peer credit instruments for hedging purposes. Key sell-side concerns CVA desk mandates Hedging credit exposures Adjusting CSAs Educating buy-side Cost impact of meeting reform requirements DVA Debt Valuation Adjustment (DVA) made headlines last year when the earnings of banks such as Morgan Stanley, Bank of America and Citigroup whipsawed as the market value of their own debt fluctuated. An IFRS13 requirement, DVA is an adjustment to the value of derivative liabilities reflecting the bank s own risk of default. Essentially, the measure allows banks to record a gain in income when market perceptions of their credit quality deteriorate, and losses when perceptions of their creditworthiness improve. A DVA gain may also be realised if a trade is unwound or novated. The measure has been criticised as being counterintuitive, for requiring hedges that may exacerbate systemic risk and introducing double counting in funding. Survey feedback indicates that, while local banks operating in South Africa have the capability to price the measure, it does not appear that they include it in pricing, nor do they hedge or monetise DVA. FVA The price at which a bank will trade an uncollateralised trade is impacted by the institution s own cost of funding. Funding Valuation Adjustment (FVA) is a fair-value adjustment applied in the valuation of uncollateralised derivatives to account for the cost of funding. A KPMG survey of offshore banks reveals a lack of consensus regarding the methodology for discounting uncollateralised deals. Not only is the funding spread to be applied a source of contention, there are concerns about the overlap of an FVA in the event of a funding benefit and DVA. FVA is similarly the source of considerable debate in the South African market, and does not yet appear to be included in pricing. With regards to collateralised deals, a KPMG survey has revealed that discounting in line with the credit support annex (CSA) has become the market standard among banks offshore. In South Africa, non-zar collateralised trades tend to be discounted using the relevant OIS rate where applicable. In the absence of a liquid local currency OIS curve, there is a move towards discounting ZAR-collateralised trades using a proxy curve based on a Jibar-derived swap curve. Some respondents have observed a shift to singlecurrency CSAs. Materiality assessments again suggest that implementation will commence with banks interest rate derivatives books. Understanding FVA Consider the example of a bank which is in-the-money on a client trade. As the trading desk would need to post collateral to the counterparty to the hedge on the trade, the desk would need to borrow money from the bank s treasury, resulting in a funding cost. If the trading desk is out-of-the-money on the trade, it will receive collateral from the counterparty to the hedge, which (if rehypothecable) could be lent to the treasury, resulting in a funding benefit.
8 Survey feedback reveals a duality in the South African financial landscape OTC reforms a wait-and-see approach According to the Bank for International Settlements, the notional amount outstanding of the global OTC derivatives market was US$647 trillion as at December 2011. The Financial Stability Board (FSB) Peer Review of South Africa reveals that the notional value of the South African OTC market was estimated at R27.7 trillion in June 2012. Of this, interest rate derivatives were estimated to comprise 85% of the total, foreign-exchange contracts 12%, with the balance made up of equities, credit and commodities. The majority (59%) of OTC interest rate transactions were estimated to be conducted in the interbank market. 2 At the Pittsburgh summit in 2009, the G20 Leaders agreed that all standardised OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest. OTC derivative contracts should be reported to trade repositories. Non centrally-cleared contracts should be subject to higher capital requirements. In 2011, the G20 Leaders further agreed to add margin requirements on non centrally-cleared derivatives. As a member of the G20, South Africa has committed to implementing these reforms, addressing them through the framework of the Financial Markets Act. Survey feedback reveals a duality in the South African financial landscape: while the financial market infrastructure is being frantically developed to address these reforms, participants are in a holding position, waiting for further clarity from authorities and to see what other market participants will do. According to the Financial Stability Board s Peer Review of South Africa, a phased approach has been adopted to implement these reforms: Phase I a code of conduct for, and registration of, market participants and implementing central reporting of OTC derivative transactions Phase II risk management, i.e. margin and capital requirements for non centrally-cleared derivatives (where appropriate) Phase III standardisation, central clearing and central trading (where appropriate). Key buy-side concerns Identifying ways of reducing CVA charge Cash flow management and liquidity Impact of reforms on derivatives strategy 2 Source: http://www.financialstabilityboard.org/publications/r_130205.pdf
9 Centrally-cleared derivatives attract a lower capital charge to cover CVA VaR. Basel III permits banks to apply a 2% risk weight to cleared exposures, provided that the Central Counterparty (CCP) meets guidelines set by the Committee on Payment and Settlement Systems (CPSS) and the International Organisation of Securities Commissions (IOSCO). Rather than mandate the clearing of standardised contracts, South African authorities hope that this will provide sufficient incentive to participants to fulfil this G20 commitment. The JSE s subsidiary, Safcom, has recently been certified as a qualifying central counterparty for exchange-traded products becoming the first in the world to qualify for CPSS-IOSCO compliance. In March 2013, the JSE further announced the promulgation of rules enabling the establishment of a default fund. These initiatives form part of the JSE s plans to launch an onshore domestic OTC CCP an area of major focus for the JSE and one it hopes to implement by the end of 2013. In the interim, and to cater for the significant interbank trade between South African and offshore banks, National Treasury has granted approval until December 2013 for rand and foreign currency to be used as initial and variation margin. As at June 2012, approximately R8.5 trillion 3 worth of interest rate derivatives were traded between South African and offshore banks based on figures presented in the FSB Peer Review report. FA News reported that Absa concluded the first South African cross-border standardised OTC derivatives transaction cleared using an offshore CCP LCH.Clearnet in the UK in January 2013 4. Although banks anticipate a push to clear through a local clearing house, they are concerned about the appetite of their offshore interbank counterparties to clear through a domestic CCP. Buy-side views around these developments vary widely. For some survey respondents, posting initial and variation margin was not viewed as a stretch too far from their existing bilateral CSA agreements. Others expressed concern that margining would introduce undesired complications and inefficiencies in cash flow management. Concerns were also raised over restrictions on the assets that would be eligible as collateral. While some respondents welcomed greater pricing transparency from the standardisation of contracts, others viewed the lack of positioning anonymity to be disadvantageous. For many, bespoke structures form an integral part of their investment strategy and they decried that advantages, such as tax benefits, would be eliminated by a move to standardised contracts. Central clearing and standardisation should, in theory, lead to increased volume, tighter spreads, lower margins, and a more commoditised market. However, respondents expressed concern that, initially, the move could result in fragmentation, lower liquidity and increased costs. Trade repository In the 2008-09 crises, regulators lacked oversight of the accumulation of concentration risk amongst institutions and the systemic risk these positions posed to their economies. Trade repositories are intended to provide regulators with a complete overview of the OTC derivatives markets. The Financial Markets Act provides for the creation of a trade repository that will maintain a secure and reliable central electronic database of transaction data pertaining to all open OTC derivatives, disclosing this information to regulators so that they are able to monitor potential risks. Strate is applying for the licence to operate the Trade Repository for the South African market. Graphic: 2009 G20 Summit OTC derivative reforms 2009 Pittsburgh G20 Summit All standardised OTC contracts should be traded on exchanges or electronic platforms, where appropriate All standardised OTC contracts should be cleared through central counterparties All OTC derivative contracts should be reported to trade repositories Non-centrally cleared derivative contracts should be subject to higher capital requirements 3 Source: http://www.financialstabilityboard.org/publications/r_130205.pdf 4 http://www.fanews.co.za/article.asp?company_news_results~1,absa~1136,absa_successfully_clears_first_south_african_over_the_counter_ derivatives_trade~13052
10 The South African derivatives market is facing a game-changing industry shake-up that looks set to fundamentally change its operational structure. Firms have to access the strategic and operational impacts of the various regulatory proposals. Where KPMG can assist Training Pitched at key stakeholders, KPMG provides insight into the role of the CVA trading desk, the related practical and operational considerations as well as the challenges of CVA, DVA and FVA implementation in the South African market. Implementation KPMG can assist with: Basel III implementation Counterparty Credit Risk framework design and implementation Development and review of Requests for Proposal to software vendors Vendor selection for software solutions Translating business requirements from Front Office and CVA desks to specifications for developers Strategy design, infrastructure specification and operational implementation of CVA, DVA and FVA OIS discounting framework implementation Assessment: Model calibration and validation CVA gap analysis and benchmarking against industry peers Regulatory impact analysis Counterparty Credit Risk methodology reviews and validation
Contact us Alison Beck Partner, Financial Risk Management Advisory M: +27 (0)11 647 7294 E: alison.beck@kpmg.co.za Urbanus Vermeulen Partner, Financial Risk Management Advisory M: +27 (0)82 719 2268 E: urbanus.vermeulen@kpmg.co.za Bianca Ruddy Senior Manager, Financial Risk Management Advisory M: +27 (0)82 712 7027 E: bianca.ruddy@kpmg.co.za Simona Levet Manager, Financial Risk Management Advisory M: +27 (0)82 254 8369 E: simona.levet@kpmg.co.za kpmg.co.za The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation. 2013 KPMG Services Proprietary Limited, a South African company and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative ( KPMG International ), a Swiss entity. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International Cooperative ( KPMG International ), a Swiss entity. MC10199