The derivatives landscape has evolved greatly over the past few years, driven by the scale and pace of regulatory change, economic unease and competitive pressures. So how can firms construct scalable, next-generation technology building blocks to respond to the challenges of today and be flexible enough to adapt to the world of tomorrow? In today's innovation environment, large global enterprises have completely rethought how they build and deliver software using bleeding-edge technology. This new-age design philosophy is called microservices, a direction that fundamentally requires the structure of risk technology.
This article first appeared as part of the November 2016 cover story in Wilmott Magazine. The story ‘Vive La Difference’ observes that with the continued migration of quant skills throughout the finance industry, it is now diversity that defines current trends in technology for quantitative finance. The full article can be accessed here.
Derivatives Week - by Dmitry Pugachevsky, Quantifi
Are banks ready for counterparty risk elements of Basel lll? Enhancing counterparty credit risk management practices is a key focus for banks. This is in response to changes in accounting rules and new prudential and market regulations, which have tightened substantially following the financial crisis. Collectively, these changes are having a deep impact on the market and the way banks price and manage the risk associated with derivatives. The survey was conducted at the Quantifi and EY London seminar 'Managing Counterparty Risk & Basel III' where over 120 senior traders and chief risk officers from global and regional banks were surveyed about their approaches toward counterparty credit risk and Basel III.
Derivatives Week - by InteDelta and Quantifi
The measurement and management of counterparty risk is in the midst of a revolution. Within recent memory of most counterparty risk managers it all used to be so much simpler. Limits were set on the same basis as traditional lending, and exposure measured against those limits was quantified using simple add-on factors applied to the notional of each transaction. Regulatory capital was based on the simple methodology specified under Basel I.
Derivatives Week - by Risk Dynamics and Quantifi
There is a strong market focus on counterparty credit risk, in particular Credit Value Adjustment (CVA). The attention is predominantly towards the issue of efficient CVA pricing as opposed to implications in terms of risk management and capital requirements. However, since the recent crisis, another issue has gained prominence; the significant losses that counterparty credit risk can cause if not correctly managed. This article studies the conditions for the effective management of counterparty credit risk by detailing and comparing capital requirements, identifying inconsistencies in prudential regulations and applying various capital approaches on typical portfolio strategies observed within financial institutions.
TabbFORUM - by Rohan Douglas, Quantifi
Prior to the credit crisis, interest rate modelling was generally well understood. Credit and liquidity were ignored, as their effects were minimal. Pricing a single currency interest rate swap was straightforward: a single interest rate curve was calibrated to liquid market products, and future cash flows were estimated and discounted using this single curve. Today, a new interest rate modelling framework is evolving. Pricing a single currency interest rate swap now takes into account the difference between projected rates such as Euribor that include credit risk and the rates appropriate for discounting cash flows that are risk-free or based on funding cost. This approach is referred to as OIS discounting. In addition, the counterparty credit risk of (uncollateralized) OTC transactions is measured as a CVA.
Derivatives Week - by Dmitry Pugachevsky & Rohan Douglas, Quantifi
The global financial crisis brought counterparty credit risk and credit value adjustment (CVA) very much into the spotlight. The Basel III proposals first published in December 2009 introduced changes to the Basel II rules, including a new capital charge against the volatility of CVA. As the Basel committee noted, two thirds of the counterparty risk related losses during the credit crisis were actually from CVA volatility rather than defaults. Not surprisingly then, the new CVA ‘VaR capital charge is quite punitive and worthy of focus. There are two ways for a bank to compute CVA VaR--what are commonly called the standardized and the advanced methods.
Total Derivatives - by Dmitry Pugachevsky, Quantifi
There is still industry discussion how best to calculate Funding Valuation Adjustment (FVA). However, an even bigger debate is centered on the question: assume that banks know FVA, how should they handle it? A previous article published on Total Derivatives 'The impact of FVA on swaps - a primer' introduced FVA and outlined different scenarios when it has to be calculated. It also demonstrated the role of wrong-way risk, including one arising from a correlation between the default risk of a bank and its counterparty. This article outlines the ongoing industry debate on how to treat FVA - as part of risk-neutral pricing or as an extra cost of a trade.
Derivatives Week - by Dmitry Pugachevsky & Rohan Douglas, Quantifi
Market best practice implemented by the most sophisticated banks now accurately measures all the components of a trade to analyse its profitability including Credit Valuation Adjustment (CVA), the Cost of Regulatory Capital (CRC) and most recently Funding Valuation Adjustment (FVA). Accurately measuring these components requires taking into account the OTC trades done across all desks with that counterparty, along with the collateral posted or received as part of any CSA. This is a significant new challenge for OTC businesses that has traditionally been siloed with often-separate front office analytics and systems.
Journal of Securities - by Dmitry Pugachevsky & Rohan Douglas, Quantifi
The cost of funding has become a significant topic for financial institutions as it is regarded as a key component in analysing the exposures and profitability of a trade. FVA is the latest market innovation that has rapidly become the standard for measuring this cost. FVA is the latest in a triad of valuation adjustments (CVA, DVA and FVA), which has to be taken into account when profitability of the trade is estimated. Unlike CVA, it is the cost that cannot be passed to the counterparty, therefore knowing it is imperative for successful management of the trading book.
The implementation of new regulations including Dodd-Frank, MiFID II, EMIR and Basel III is significantly increasing the cost of capital and forcing banks to re-evaluate the economics of their OTC trading businesses. Understanding trade profitability becomes critical with banks now pricing all the components of a trade including the model value using the appropriate discounting curve, the Credit Valuation Adjustment (CVA), the Cost of Regulatory Capital (CRC) and most recently the Funding Valuation Adjustment (FVA).
Creditflux - by Dmitry Pugachevsky, Quantifi
One of the challenges in investing in credit linked notes (CLN) is the shortage of high quality debt for funding. This article explores a new type of trade - CLNs with risky collateral. It highlights that by taking into account all possible risk, including uncertainty of market value at early redemption, one can calculate values and sensitivities of such products, and trade them consistently as traditional CLNs. The article also outlines how any type of credit derivative can be structured as a funded note supported by collateral that can default before deal maturity.
Derivatives Week Learning Curve - by Quantifi
The credit crisis and regulatory responses have forced banks to update their counterparty risk management processes substantially. New regulations in the form of Basel III, the Dodd-Frank Act in the U.S. and European Market Infrastructure Regulation (EMIR) have dramatically increased capital requirements for counterparty credit risk. CVA desks have been developed in response to crisis-driven regulations for improved counterparty risk management. How do these centralized groups differ from traditional approaches to manage counterparty risk, and what types of data and analytical challenges do they face?
Derivatives Week, Learning Curve
One of the key shortcomings of the first two Basel Accords is that they approached the solvency of each institution independently. The recent crisis highlighted the additional 'systemic' risk that the failure of one large institution could cause the failure of one or more of its counterparties, which could trigger a chain reaction. Whereas Basel III represents progress, there are several ongoing challenges. The first set of challenges has to do with the regulation itself. The timeline provides for a phased implementation period extending out to 2019. Another crisis could certainly occur within that time. The second set of challenges is structural. Banks are moving toward active management of counterparty risk.
Derivatives Week, Learning Curve
A new generation of interest rate modelling is evolving. An approach based on dual curve pricing and integrated CVA has become the market consensus. There is compelling evidence that the market for interest rate products has moved to pricing on this basis, but not all market participants are at the stage were existing legacy valuation and risk management systems are up to date. The changes required for existing systems are significant and present many challenges in an environment where efficient use of capital at the business line level is becoming increasingly important.
Structured Credit Investor
Quantifi explores the key challenges for banks in the implementation of counterparty risk management, focusing on data, technology and operational issues in the context of current trends and best practices Most banks are in the process of setting up counterparty risk management processes or improving existing ones. Unlike market risk, which can be effectively managed by individual trading desks or traders, counterparty risk is increasingly being priced and managed by a central credit value adjustments (CVA) desk or risk control group since the exposure tends to span multiple asset classes and business lines. Moreover, aggregated counterparty exposure may be significantly impacted by collateral and cross-product netting agreements.
In the aftermath of the credit crisis, spreads soared to unpredicted heights. Practitioners had to revise valuation methodologies to reflect these changes in the market. The accounting profession is now recognizing that these new market practices have important accounting implications as well. The new multi-curve interest rate curve paradigm has a significant impact on the value of all derivative transactions. To comply with FASB 133/157, ISA 39, IFRS 9/13, this new valuation methodology needs to be implemented and accounting valuations have to reflect this new market standard.
Structured Credit Investor - by Rohan Douglas, Quantifi
Q: How do you differentiate yourself from your
A: One differentiator is that our technology infrastructure was built from the ground up. Whereas other vendors may offer, for example, add-on scenario analysis functions, we can produce faster results because it has always been an integral part of the risk engine. Equally, our analytics library was built on a .Net platform, so performance has always been a element of the product. Another differentiator is that we bring on board experienced people from the industry, so we better understand the nature of our clients' needs.
Quantifi CEO Speak with Credit Magazine
Q: What will be the long-term consequences of the crisis on confidence and liquidity? What kinds of institutions will have to make the biggest changes to their processes and will some of the more exotic structured finance products simply not get done any more?
A: Looking at similar crises in the past, I would expect the market to learn some lessons but bounce back even stronger than before. The structured finance and credit derivatives markets have, over time, proven to satisfy fundamental investor demands and should be expected to continue to grow steadily. There may, however, be an increased demand for structures that are more uniform and transparent. In a new world where credit risk is more widely disseminated, the science of understanding and
It has been reported in several industry publications (e.g., CreditFlux, Reuters, Derivatives Week Online) that the CDS market is likely to switch to a fixed coupon basis with upfront points. This change will lead to some fundamental changes in the risk profiles of these contracts. Understanding the implications of a switch to upfront contracts is going to be important in adjusting hedging strategies going forward. This is particularly true for strategies involving these contracts as hedges for default risk.
Derivatives Week Learning Curve
Common market best practice for pricing off-the-run or bespoke collateralized debt obligation tranches involves mapping implied base correlation surfaces calibrated from actively traded tranches such as those on the CDX or iTraxx. The term structure approach for base correlation surfaces is an important incremental improvement over commonly used methods for dealing with the maturity dimension of base correlation surfaces. It is particularly important for longer dated equity and junior mezzanine tranches in environments where the correlation term structure is steep.
LCDS contracts are based on standard corporate CDS contracts, with a few modifications to address the specific nature of the loan market. The central difference is that LCDS is referenced to the issuer’s secured loans only and not to the general obligations of the issuer, as is the case in standard corporate CDS. As such, the recovery on the event of a default for an LCDS is expected to be significantly higher that that of a CDS. The second difference is the LCDS cancellability feature. LCDS contracts may be canceled if the underlying reference loan is refinanced or otherwise retired.