Nov 30, 2015

Derivatives Industry Update | FRTB CVA Framework & ISDA SIMM Methodology

In this video blog Jim Jockle, CMO of Numerix speaks with Kevin McPartland, Head of Market Structure and Technology at Greenwich Associates about trends in volatility. - See more at: https://www.numerix.com/volatility-focus-should-we-fear-vix#sthash.ySpVmlHh.dpuf
In this video blog Jim Jockle, CMO of NumerixIn this video blog Jim Jockle, CMO of Numerix

In this video blog Jim Jockle, CMO of Numerix and Dr. Serguei Issakov, SVP of Quantitative Research at Numerix discuss the latest extensions and revisions to bank capital requirements under Basel III. Serguei explains how the existing CVA capital regulation is being revised to better align with FRTB, and how FRTB overall is serving as a unifying framework for different approaches to the calculation of regulatory capital.

As the newly proposed FRTB CVA framework is being reviewed, Serguei also explores the challenges institutions are facing as they look to comply with ISDA SIMM methodology. Lastly Serguei touches on MVA or the Margin Valuation Adjustment, specifically what should people be thinking about as they are incorporating the concepts of MVA into their total workflow.

TRANSCRIPT:

Jim Jockle (Host): Hi Welcome to Numerix Video Blog. I’m your host Jim Jockle. As we’re quickly closing the books on 2015, 2016 promises more cost, and that cost is directly impacted by two elements in the market. First, is the introduction of certain deadlines as it relates to FRTB under Basel III rules, and the second is the introduction of ISDA SIMM Methodology, which is margin for non-cleared derivatives.
 

Interestingly, just before Thanksgiving here in the United States, Basel just put out its interim impact study, looking at some of the effects on FRTB. And, the report had concluded that we’ll definitely be seeing something of a minimum 4.7 percent in capital over the additional Basel III capital rules that have been rolled out into the banking book.

Joining me today to discuss some of those regulatory changes that have been enacted over the past few months is Dr. Serguei Issakov, SVP of Quantitative Research and Development at Numerix. Serguei welcome.

Serguei Issakov (Guest): Thank you Jim.

Jockle: Perhaps you can give us a bit of an update of some of the changes that were enacted and proposed into the market during the summer months.

Issakov: During the summer, the Basel Committee issued a new regulation, which is a substantial upgrade of the existing CVA capital regulation. And, that regulation it’s an update. It’s aligned with the FRTB approach as you said, so Basel proposed one approach which is a generalization of the standardized Basel III capital calculation for the bank that currently used this approach. And the change was to account for market fluctuations in exposures. The original Basel III CVA capital calculation accounted only on fluctuation in credit spreads for counterparty when computing CVA VaR, which is the quantity on which the CVA capital is based.

Now they are basically under pressure from banks. Banks normally do account also for fluctuations in exposures. They added this requirement to account for those fluctuations in calculation of the capital, CVA capital. That’s one part of this proposal. And, also they issued their so called FRTB CVA Framework, where they aligned the calculation of CVA capital with FRTB sensitivities, and FRTB shocks, define the FRTB approach to market data.

So now it’s interesting to note that FRTB framework serves as a unifying framework for different approaches to the calculation of regulatory capital.

Jockle: So Serguei, let me ask you a quantitative question. I don’t know if I’ll understand the answer, but… One of the things that we’re continuing to see different dislocations in the market. We’re seeing changes in credit spreads in terms of synthetic credit, widening out over cash credit, we’re seeing more and more volatility, and things of that nature.

A lot of the regulation as it was developed, especially in the terms of quantitative finance is assuming stable and predictable markets, yet right now when you start seeing different volatility swings and things of that nature. How does that impact some of these calculations? Assuming all things were equal in terms of credit spreads, but yet you see a market dislocation. How is that going to disrupt some of these models?

Issakov: Well, definitely the models will have to be adopted to be able to handle large volatility changes, volatility spikes and different volatility regimes.  But, that’s what quants have been working on all the time, when such regimes do occur in the market. Definitely, increasing credit spreads would increase the capital charges.  But, that’s basically how we can just react and account for those fluctuations in the market.

Jockle: OK. Very good. Thank you.  Just turning over to some of the SIMM Methodology. What are some of the challenges that people are thinking about as they are looking to implement this?

Issakov: Well, the SIMM Methodology which was issued by ISDA, it’s a Standardized Initial Margin Model. It looks like it is going to be accepted in all regions of the world. And, the Methodology is pretty simple in the sense that if you are able to compute sensitivities according to the FRTB approach, then, the rest is pretty straight forward.

But the correct computation of those sensitivities is a real challenge. You have to be able to compute them in an accurate way.  And this is where models, in fact front office models, become more important for the computation of those sensitivities.

 

 

Jockle:  And obviously this this will ultimately lead into the introduction of the MVA, the margin Valuation Adjustment. Perhaps, what should people be thinking about as they are incorporating the concepts of MVA into their total workflow?

Issakov: Absolutely. MVA, is similar to KVA, which is the cost of your capital throughout the life of your portfolio of trades. For margin, when margin requirements are applied, you have to be able to compute your margin requirements again throughout the life of your portfolio. And, well, based on the approaches for margin calculation itself you can simulate the calculation, you can simulate the MVA. Well, MVA is the cost of margin. The Methodology is similar to the calculation of KVA. In fact, you can say that even for MVA based on initial margin for bi-lateral trading, mathematically it’s very similar to KVA for market risk capital.  Mathematically, it’s almost identical, in fact. So, if you know how to compute one, you know how to compute the other.

Jockle: Well, finally something easy in the world of quantitative finance.

Issakov: Yes.

Jockle: Well, Serguei I want to thank you for joining us. Of course, stay on top of all the things that Numerix is putting into the marketplace. Look for our new paper on FRTB that will be available on numerix.com. Thank you so much for joining. 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 so much for your insights on the topic.

Issakov: Thank you Jim.

Jockle: And, we’ll see you next time.

Blog Post - Sep 24, 2010

Implementing Change in Derivatives Regulations

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