May 21, 2015

Are We There Yet? Derivatives Industry Update on CCR Capital, KVA and Margin Calculation

In this video blog, Dr. Serguei Issakov, SVP of Quantitative Research at Numerix breaks down the final ruling for calculating counterparty credit risk capital. Serguei discusses the standardized approach to the CCR capital requirement, as well as the CVA capital charge as outlined by Basel III.

He offers his perspective on the preparedness of banks ahead of the implementation deadline. As KVA has also emerged, Serguei stresses the various methodologies that are being adopted, and explains the role MVA and how the funding of initial margin is coming into play.

Weigh in and continue the conversation on Twitter @nxanalytics, LinkedIn, or in the comments section.

Video Transcript:

Jim Jockle (Host): Hi welcome to Numerix Video Blog, your expert source for derivatives trends and topics. I'm your host Jim Jockle.

The Basel Committee's final ruling on standardized approach for measuring counterparty credit risk exposures was announced in April of last year, where all banks much comply by January 2017.  Also on the forefront is KVA, though not yet required by regulators, KVA is recognized as the cost of holding bank capital against the risk of a trade on all dates into the future. Joining me today for this discussion is Dr. Serguei Issakov, SVP of Quantitative Research at Numerix. Serguei, welcome.

Serguei Issakov (Guest): Thank you, Jim.

Jockle: So, Serguei, perhaps we can start from your perspective as it relates to how prepared are banks? Are they incorporating these calculations, or, where are we as it relates to the timing of those rules and the rollout?

Issakov: OK. As you said Jim, this new regulation [SA-CCR], recent regulation from the Basel committee appeared only in April last year. But it is the final regulation for Counterparty Risk Capital that corresponds to realized defaults. And there are actually two types of capital in Counterparty Risk, one is this for realized defaults, which was issued in April of last year and the other one is CVA capital charge, which is a Basel III rule. Now both are defined in the final form, so banks have to work to implement that. But, because that deadline is January 2017, it's not clear how many banks actually did implementation, did this work.

Jockle: So I want to talk a little bit, specifically around KVA. There are many methodologies right now and no standardization as it relates to the calculation of KVA. Perhaps you can shed some light and insight as it relates to these methodologies and do you see an emerging standardization, similar to what we've seen in terms of CVA through the rollout coming to the market at any time soon.

Issakov: If you look at this table, which represents different types of capital and KVA, you can see that KVA in fact is much more complex than CVA, DVA, or even FVA. Because KVA corresponds aggregation of future capital for different types of risk. In this table you can see that there is a component corresponding to the market risk and then two for the counterparty credit risk, and you can add even more, say operational risk in the future. And, even for capital, which is capital as of today which is required by regulators there are different approaches.

The standardized approach has been formulated recently, in final form, except for market risk. For market risk the standardized approach has been formulated in the preliminary form in this fundamental review of the trading book document, which is in one of the boxes in this table.

CAPITAL
 
MARGIN (INITIAL MARGIN / VARIABLE MARGIN)
Method / Risk Type
Market Risk
CCR (realized defaults)
CVA Capital Charge (Basel III) bcbs189 (2011)
Standardized
FRTB MR SA  bcbs265 (2013)
d305 (2014)
Basel 2014 standard SA-CCR bcbs279
bcbs189 (2011)
IMM
Risk Neutral / Real World
Risk Neutral / Real World
Risk Neutral / Real World
 
d317 (2015) BCBS / IOSCO
"Schedule" d317 (2015) BCBS / IOSCO

 

 
KVA
 
MVA
Method / Risk Type
Market Risk
CCR (realized defaults)
CVA Capital Charge (Basel
III)
bcbs189
(2011)
Analytic
Exposures
 
 
 
Simulation
Based Exposures
 
 
 
 
 
 


 

 

But in addition to the standardized approach, there are approaches that are based on simulations of exposures. So for each box of a standardized approach, there is a corresponding approach to, which is called sometimes IMM approach, Internal Model Approach for computing capital. And then if you go to KVA, to each of these six boxes of capital, there is a corresponding KVA.

And also, the KVA can be computed in different ways. For the standardized approach when you can compute capital by closed formulas, the KVA computation is also simple, and you can call it analytic KVA. But the most complex approach is to incorporate actual simulation, both for scenarios and for computing capital on future dates.

Jockle: And that's for real world or risk neutral?

Issakov: That's both. And, on top of that, simulation of your portfolio on those scenarios. And as you said, also, eventually, ultimately, you have to use real world scenarios to compute KVA, which is also different from FVA, for example, and CVA. So this is a very complex field, and there is ongoing research that is actively discussed at conferences where results are presented and this is a work in progress at this time.

Jockle: So let's talk about the latest VA, to the XVA party, if you will. The MVA, margin variation adjustment. So, as everyone in our field is fully observing the imposition of margin on OTC derivatives, non-cleared, whether that's initial margin or variation margin, which introduces the MVA adjustment. Perhaps you can tell us a little bit about how you see the development and relationship between the KVA and ultimately the MVA once these rules are rolled out.

Issakov: Well, MVA corresponds to recent regulations, actually as of March of this year, very recent. That were issued for for margin rules for OTC derivatives, initial margin and variation margin. There is again a standardized approach to that, which is in the final form now, and it will be in effect September 1st of next year, which is very near. MVA is a pretty new concept, but by analogy with all these valuation adjustments, of course, if you have a computation of margin, you have to include the effect of that computation into your price, like for other valuation adjustments XVA and KVA also. So, this concept's methodology appeared, in fact, only this year, but, it naturally fits into the XVA valuation framework, as a natural component, so if you want to account for initial margin, you have to account for MVA.

Jockle: Well Serguei thank you so much and clearly we have some milestones that we're going to have to be watching and I'd love to have you back for further discussion, especially as we start seeing a little bit more standardization and clarity come across the market. And of course on the Numerix Video Blog, it's our goal to examine the topics that you want to talk about, so please keep the conversation going on LinkedIn or on Twitter @nxanalytics. Thank you for joining us and Serguei, thank you so much for your insights on the topic.

Issakov: Thank you, Jim.

Jockle: We'll see you next time.

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