As a provider of credit analytics, risk management and XVA solutions to hedge funds and banks, Quantifi has noticed a very interesting development – the emergence of CVA (Credit Valuation Adjustment) swap market. The nature of these transactions closely resembles the interaction typically observed between an XVA desk and a trading desk within a bank when adding a new derivative trade. We anticipate that the CVA swap market will play a pivotal role in financial markets, offering participants a means to mitigate counterparty credit risk in over-the-counter (OTC) derivatives.
The structure of the new CVA swaps closely mirrors the operational dynamics between a bank’s trading desks and XVA desk.
CVA swap dynamics
While SRT (Significant Risk Transfer) and CRT (Capital Relief Trade) transactions have become established practices for banks in transferring counterparty credit risk to hedge funds, CVA swaps have only recently entered the trading arena. The purpose underlying all these transactions is to enable banks to offload counterparty credit risk, thereby reducing the amount of capital they are required to hold for regulatory compliance. With rising rates and increasing volatility in credit markets, the cost of capital has surged, heightening the significance of such trades.
XVA traders are aware that each new trade executed with the counterparty can significantly increase CVA and other XVA metrics. The increase in what is termed ‘incremental exposure’ has the potential to breach limits set up by credit officers or substantially drive-up regulatory capital, particularly the Basel III CVA capital charge. To avoid such increases, banks are now opting to trade off CVA risk.
The structure of the new CVA swaps closely mirrors the operational dynamics between a bank’s trading desks and XVA desk. In this set-up, the trading desk pays an incremental CVA charge at inception of the trade, and then XVA desk hedges all the associated risks, and in the event of default bears all the losses. In the context of CVA swaps, apart from the initial upfront payment of CVA from the bank to a hedge fund, there are daily margins, i.e. the hedge fund pays the daily difference in CVA. If no default occurs before trade matures, CVA diminishes to zero at maturity. However, in the event of default, it equates to losses incurred by the bank. Note that since CVA is always negative for the bank, the hedge fund pays when CVA increases in absolute value and receives payment when CVA decreases in absolute value. For instance, if CVA changes from today’s -$1000 to tomorrow’s -$1100, the hedge fund pays $100. Conversely, if tomorrow’s CVA is -$950, the hedge fund receives $50.
Hedge funds trading CVA swaps should be able to calculate XVA sensitivities to market factors. This requires an XVA system which can efficiently and robustly generate effective hedges.
Enhancing CVA hedge effectiveness
When it comes to CVA hedges, the primary focus is hedging counterparty credit risk which typically involves buying and selling CDS on counterparty’s credit name. However, there has been a shift in the landscape, with single name CDS becoming less liquid, and a largest portion of credit trading is now done on indices. This trend contributes to banks preference for transferring CVA risk to the buy side, where credit specialist funds have better opportunities to identify suitable credit hedges – potentially involving indices or proxy hedges by single-name CDS. Additionally, market risk hedges play a key role in offsetting movements in major market factors that impact the exposure of the underlying derivative trade, such as interest rates or FX. Recently, the volatility of these market factors has significantly increased, influenced by decisions made by Central Banks or geopolitical events, underscoring the heightened importance of market risk hedging. Hedge funds trading CVA swaps should be able to calculate XVA sensitivities to market factors. This requires an XVA system which can efficiently and robustly generate effective hedges.
Building a solution from the ground up is a demanding and time-consuming process, requiring several years to build an efficient XVA Monte Carlo solution.
Cross-gamma and wrong-way risk
Lastly, there is a critical factor known as cross-gamma, reflecting the impact on CVA from simultaneous movement of market factors and counterparty spread. While challenging to hedge, cross-gamma should be incorporated into scenario analysis and P&L explain. Another analytic approach involves calculating wrong-way risk (WWR), where the growing exposure coincides with a widening counterparty spread, and the cumulative effect is a CVA increase.
It is essential to consider these risk factors when reviewing daily CVA explain. The interplay between credit and market factors is most pronounced in cross-currency swaps, particularly those that are not resettable (i.e. not mark-to-market). This has significant FX risk due to a large payment at maturity. Another scenario to be considered for such trades is jump at default, whereby the local currency of a country may devalue in the event of a counterparty (such as a major local bank) defaulting. Hedge funds engaging in CVA trades with banks should carefully consider all these factors to make well-informed decisions.
The following example illustrates the importance of WWR and especially of jumps at default. The calculations are done for at-the-money five-year non-resettable Cross-Currency swap with $10 mln notional. With regular CVA equal to -1.5%, WWR CVA increases 6% to -1.6% of notional. But even 5% devaluation at default increases CVA another 35% to -2.15% of notional. Figure 1 shows Expected Positive Exposures (EPE’s) for each of the three cases: regular, WWR, and WWR with 5% devaluation. Note that WWR could be significantly higher depending on volatilities of FX and counterparty credit and the correlation between them.
A proven XVA system for hedge funds
In general, while banks typically provide daily quotes for the current value of CVA, many hedge funds are keen to independently verify these quotes. To do this, they require a sophisticated solution capable of producing CVA and sensitivities, incorporating special features such as generating CVA P&L explain, calculating WWR and RWR, and accommodating jumps at default.
Large banks commonly have comprehensive XVA solution that incorporate the mentioned features. In contrast, many hedge funds, less familiar with counterparty risk, often do not have such systems in place. Building a solution from the ground up is a demanding and time-consuming process, requiring several years to build an efficient XVA Monte Carlo solution. Hence, buying third party solution can prove to be a more cost-effective and faster option.
Quantifi has successfully implemented its XVA solution at several sell-side and buy-side firms, with all the features described above implemented and being used by the clients. The high-performance calculation engine and sophisticated analytics support Monte Carlo simulations and path-wise pricing necessary for XVA. These calculations are highly intensive and time-consuming.
Leveraging its expertise in credit derivatives, Quantifi is well positioned to assist clients in making informed decision on credit hedges, particularly in cases where the single name CDS on counterparty credit is not sufficiently liquid.
Future-proofing CVA strategies
CVA swaps serve a very important purpose of reducing bank’s counterparty risk limits and addressing the increased regulatory capital requirements for CVA. Hedge funds with expertise in credit have an advantage in deploying credit hedges for CVA. This points towards a growing market for CVA swaps. For hedge funds, to validate bank’s quotes and calculate both market and credit sensitivities, an advanced XVA system is essential. The system should be able to calculate WWR, estimate daily CVA P&L, and incorporate devaluation scenarios. Building such a system is time-consuming, making the acquisition of third-party solutions, such as Quantifi, the most efficient, and cost-effective route.
