A recent Risk magazine article titled "Replacement Costs Add to OTC Pricing Upheaval" by Matt Cameron examines the role of downgrade triggers and the impact on key stakeholders. In this video blog Denny Yu, VP of Client Solutions and Risk Product Manager talks with Jim Jockle, CMO about today's derivatives pricing challenges – namely the notion of replacement valuation adjustment (RVA). Denny and Jim discuss this latest metric, how it can be measured, who it impacts and how banks can best manage it.
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Video Transcript: Managing the Valuation Adjustments Challenge – Understanding RVA Risk within OTC Derivatives
Jim Jockle (Host): Hi welcome to Numerix Video Blog, I'm your host Jim Jockle. With me today, Denny Yu of Numerix Client Solutions Group. How are you Denny?
Denny Yu (Guest): Good, good. How are you?
Jockle: Very good. Denny I want to talk about an article that came out September 2nd, 2013 by Matt Cameron of Risk Magazine titled Replacement Costs Add to OTC Pricing Upheaval. And if you haven't read it and you're in the market it's definitely a must read. And it's introducing basically rating triggers, back again and the development of RVA. And for those who are unfamiliar with rating triggers, they've came back into the spotlight really around Enron and then from there, were highlighted through the rating agency reform act of 2009. And we're now seeing them again and there's a lot of interesting positions on this in terms of the role of rating triggers within OTC derivatives and valuations. So Denny, really what I want to jump into a little bit is, we all know what rating triggers are, but explain this concept of RVA and how and why it is so controversial.
Yu: Sure, sure. So the replacement valuation adjustment is really a metric to measure downgrade triggers. And the downgrade triggers typically clause you would find in the CSA, or credit support annex, that is negotiated between banks and their counterparty clients. And what the clause really dictates is in the event of a downgrade to a certain rating level for that bank, the counterparty, typically the end client has the ability to force the close out. And that means that the bank will have to close out that position and replace that position with another bank. Which means they actually have to find another counterparty to step in and take over that transaction.
Now, from a risk prospective it's hard to measure, because we take into account potential down fault triggers. It takes into account the likelihood of defaults. The likelihood of the end client exercising that option to force closeout and replacement. And ultimately, a big part of this article, which is really well written around this, is the fact that these downgrade triggers exist typically for concentrated sets of banks around different types of asset classes. So, an example in the article was around inflation swaps which has a lot of the banks in the U.K. that have built in downgrade triggers with their clients. And the fact remains that in the event of a financial crisis, such as the one we've seen in 2008, most of these banks will go through downgrades and a lot of these triggers can then be kicked into effect and as a result you would see bid ask spreads explode as a result of counterparties and banks trying to replace a lot of these positions.
Jockle: But how is the market involved? You think about a couple years ago, your average bank rating was probably AA range. And we've seen continued pressure, downward rating pressure, and the triggers were really coming in at that BB range, there's not a lot of room here, especially if you're looking at any point and time of multi-notch downgrade. So it's clear on a systemic risk but how should practitioners be thinking and preparing as for those institutions that might be getting closer to a trigger or in the event of a multi-notch downgrade. What kind of defense mechanism can you have in place?
Yu: Well it is a difficult question. So you can think of it from the end client side, you can think of it from the bank side. If you look at the history of why these downgrade triggers exist in the CSA's, it was really to gain market share. So during times where these banks were highly rated, it was a free option that was offered to end clients to win market share. And I don't think there was really a lot of work around, or belief that many years from those initial transactions we'd be at the rating levels that we see banks at today. So that was really not something that was actively managed.
Now, it comes into the forefront because we are in a different environment. Banks are at much lower ratings than they were in the past decade and as a result, banks have to manage this potential risk. End clients, who are still looking to be able to exercise these options or be able to still embed them in new swap transactions, are looking to have this type of exit strategy. How do banks manage this today? That's a big question mark. So a lot of inputs go into this.
We've talked about in the past calculating CVA and DVA and those require some assumptions. RVA requires even more assumptions. It basically is managing and estimating default likelihood of the own bank. And you can do that through bond spreads and credit spreads. But you have to also measure the likelihood of your end client actually exercising that option. And they may choose not to do that – or to do that depending on the benefits for them. And they may find it very difficult to find that estimation.
Jockle: Well we've done a lot really around the release of the new standard CSA, and reduction of optionality. Has this been addressed in the new standard CSA?
Yu: In the new standard CSA you don't actually see much on the downgrade triggers. We've moved to a smaller set of currencies that can be posted as collateral. A smaller set of eligible collateral securities that could be posted so we're reducing some of the optionality around the currency that can be posted and certainly around the downgrade rating triggers. But as you said, the standardized CSA is going to take a while to roll out and it's something that will take several years to roll out and a lot of banks are trying to negotiate with their counterparties and their end clients to be able to move into that regime. Until then, these banks still have to deal with this potential RVA risk.
Jockle: Now let's go on to the flipside for a second here. We're really talking in the context of the major dealer and you've talked a little bit about those on the other side of the trade of the counterparty. We're also going to start running into the same problem that we've seen in the CDS market right? So you have very liquid names. Highly rated entities, but there's on the other side of the trade, there aren't a lot of public credit ratings for smaller type firms. Or where there are bonds, for credit dispense they're not actively traded so we're in interpolation of a probability of default. How is that going to get managed and looked at or is that going to be managed through traditional CVA type charges, or DVA type replacements?
Yu: I think you're going back to really around the counterparty credit risk of the corporate clients, the pension clients, where you don't have a lot of public information around their bond spreads or their - there's no traded CDS on their name. In most cases, banks will have their internal rating models. Where they actually map either proxy indexes for credits or they'll have their actually own rating models that determine default probabilities for those corporate issuers.
Jockle: So last question. So the spaghetti bowl of acronyms is getting bigger and bigger and bigger. Who should be worried about RVA? Who is the practitioner in the bank that should be reading this article today and be adjusting this into their thought process?
Yu: Well this is fundamentally a pricing issue. So the front office team that's valuing the trades, managing and entering into these types of trades, they will be the ones that have to deal with most of the headache around these valuation adjustments. The middle office, risk side, is starting to get their hands around and heads around what all the different "XVA" charges are. And that's plenty of work to deal with before even trying to measure and monitor the RVA.
Jockle: Denny I want to thank you so much. The bottom line is 1+1+1+1 equals EVA, the economical valuation adjustment and getting to that true P&L. Clearly the valuation process continues to evolve. And it's touching all elements of the institutions and we're going to continue to stay on that topic. We want to hear from you and make sure we're covering the elements that you want to hear about and follow us along on twitter @nxanalytics or on LinkedIn to stay on top of everything that we're coming to market with. Denny thank you so much.
Yu: Thank you.
Jockle: And have a good day.
