Mastering XVA dynamics from the buy side

Amid fluctuating prices and macroeconomic uncertainty, buy-side firms are taking a more proactive role in challenging the derivatives valuations of their sell-side counterparties

With high interest rates and volatile markets, derivatives valuation adjustments (XVAs) are again rising in prominence as crucial factors impacting the earnings of financial institutions. Managing XVAs and their components – such as credit (CVA), debit (DVA) and funding (FVA) valuation adjustments – is most often discussed from a sell-side perspective, but less so from a buy-side point of view.

In a Risk.net webinar sponsored by Numerix, three experts discussed key aspects of XVA from a buy-side standpoint and strategies for navigating this increasingly complex terrain. This article examines the key themes that emerged from that discussion.

The buy side and XVAs

Derivatives play a key role for buy-side firms hedging exposure to market risks. Erik Vynckier of Foresters Friendly Society said: “Insurance and pension funds have significant exposure to interest rates, inflation and foreign currencies. Often, however, the asset side of the balance sheet will not have the right size interest rate sensitivity compared to the liability side. To avoid unintended exposures on the balance sheet, you need to employ hedging strategies, which means trading over-the-counter [OTC] derivatives.”

Trading OTC derivatives introduces a number of questions for the buy side, including valuation, whether trades are to be collateralised and if there is to be a clearing mechanism. Since the global financial crisis that began in 2007–08, derivatives valuation has grown in complexity, incorporating an increasing range of risk factors – from credit and funding to margin and capital – that can have a dramatic impact on pricing and competitiveness.

Collateral and the cost of funding

The current high interest rate environment poses a number of challenges for buy-side firms attempting to manage XVAs, particularly in terms of collateral and the cost of funding. Anastasios Hamosfakidis of Hydro Wind Energy said: “If you’re from the buy side, you’re always collateralised, which brings the cost of funding into the equation. You need to consider which collateral you will use; it may be cash, it can also be gilts or other instruments but, if you don’t have access to these, you need access to the repo markets for funding.”

Increasingly, buy-side players are seeking more flexibility in what can be used for collateral. Andrea Allegra at Numerix said: “High interest rates are having a huge impact on the propensity to use cash as collateral because it is more expensive.”

Accessibility of cash was also identified as a challenge because many on the buy side invested in less liquid positions during the years of quantitative easing, which has made it more difficult to use securities to post as collateral or to liquidate these positions.

The broadening range of instruments used for the collateral process introduces additional considerations for managing funding costs. Hamosfakidis said: “Cash is a rare commodity now – especially on the buy side. Many players are turning to gilts and other treasury bond instruments for the collateralisation process. Consequently, you have to find an optimal way of using cash, gilts and bonds so you can achieve the best optimisation strategy for your funding costs.”

A key issue is the challenge in valuing non-cash collateral, which generally incurs extra fees from dealers. This is particularly important when modelling future collateral needs. Allegra said: “This introduces issues in the pricing engine because you need to simulate not just the future of cash collateral, where the main driver is the interest rate component, but you also need to factor in a credit component for non-AAA rated government bonds, for example.”

The panel noted the importance of working together as an industry and with regulators to develop a better framework to determine what can be used as collateral and how this works in extreme markets. Hamosfakidis said: “In low interest rate and low volatility markets, bonds, and so on, are nice to have. But when the markets are extreme, what happens next? Are you going to exercise margin calls all the time? Are you going to be bailed out by the government or central bank? It’s a tricky situation that has yet to be resolved.”

A key challenge in developing frameworks is ensuring the new rules don’t create further problems and that a long-term vision of the future is considered.

Regulatory change

Regulatory change remains a key challenge in the XVA space, though its impact has diminished in recent years compared with the aftermath of the financial crisis when there was a significant focus on identifying weaker counterparties and managing counterparty risk.

One of the main challenges from a regulatory perspective is the introduction of new capital standards and how they impact the cost of capital, Allegra noted. “Historically, the buy side has focused on the cost of funding, but the way regulatory standards have changed over time means that the cost of capital and how you calculate the total valuation adjustment is also an increasing consideration.”

These changing standards present technological hurdles for the buy side, which traditionally has been less advanced in terms of modelling capabilities and access to market data.

Counterparty relationships and CSAs

From a counterparty perspective it was noted that, while in recent years the buy side tended to be on the receiving end of collateral, the increase in interest rates has seen this dynamic reverse. Additionally, buy-side firms are increasingly requesting credit support annexes (CSAs) that allow them to post different types of collateral beyond just cash – also known as dirty CSAs.

With XVAs, the choice of counterparty and the CSA’s collateral terms can have significant consequences in monetary terms. Using a sample swap portfolio for illustrative purposes, Vynckier noted that CVA charges can differ by as much as 20 basis points, adding: “We’re talking big numbers here, which is why you need to have the analytical insight to understand if you are being ripped off.”

Strong internal knowledge of XVAs is key, which can be challenging because – in comparison to the sell side – the buy side typically has fewer XVA-dedicated resources. “Investment banks have armies of people working on this. Asset owners might have a handful of traders or one risk manager, but you still need to see eye-to-eye with these people,” said Vynckier.

CSAs are particularly important in this context for setting out the parameters of the agreement and what collateral can be used. For bilateral arrangements, having access to strong analytics, which can provide guidance on whether trades are fairly priced, was considered essential. Allegra noted how the buy side was increasingly negotiating on price: “Historically, buy-side firms were price-takers and accepted quotes from dealers. Now, they are increasingly challenging those quotes, leveraging technology to get a confirmation of the quote and trying to figure out whether the quote they have is reasonable, or if the markup the dealers are asking for is too much.” However, the point was also raised that there is limited scope to play the competition against one another, given this can reveal your position to the market, and then the market can move against you.

The type of counterparty, along with the type of instrument, also influences the type of XVA used. In particular, if a clearing house is used, this changes the funding requirements. Vynckier said: “If you have to clear the trade, many of the costs [compared with a bilateral arrangement] collapse. But going through clearing means you need the cash in hand for the initial margin. If you don’t have the cash in hand, you will use the repo markets. So it becomes an equal cost.”

It was also highlighted that not everything can be cleared, and bilateral arrangements are still often required, which is where CSAs are so important in terms of collateral management.

XVA analytics

The increasingly complex environment was considered to have a number of implications for XVA calculations. Allegra said: “If you want to stay one step ahead, you need to simulate future exposures as well as future capital. You also need to simulate the regulatory environment, which will change over time. Ultimately, you need to calculate how the cost of your capital today will change throughout the whole life of the portfolio, which introduces a lot of technological challenges.”

Conclusion

The high interest rate, uncertain market environment has upended the status quo for XVAs. For many years, buy-side institutions were more often on the receiving end of collateral, and low interest rates meant funding costs were minimal. Now, collateralisation is increasingly a two-way street and XVA charges can have significant cost implications for asset owners.

In addition, buy-side institutions are pushing for greater flexibility when it comes to the instruments put forward for the collateralisation process. In this context, the use of strong analytics to negotiate with the sell side and ensure quotes are fair is more important than ever, and CSAs play an increasingly important role in collateral management. This presents considerable technological challenges, which the buy side must factor into its planning as it recalibrates how it approaches this complex area.
 

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