Regulatory update: Impact of CVA for hedge funds, pension funds, asset managers and corporates.

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Under the current banking regulations, banks are subject to a capital charge primarily to cover the losses arising from the actual default of a counterparty of an over-the-counter ('OTC') derivative contract. Under the proposed Basel III framework, the capital charge will be enhanced by a new charge, called the Credit Valuation Adjustment ('CVA') Risk Capital Charge. This is a capital charge, whereby the bank is required to hold additional capital when entering an OTC trade. The charge is designed to cover losses arising from the fact that as the counterparty's financial position worsens, the market value of its derivatives obligation declines, even though there might not necessarily be an actual default. The charge incentives hedging, a failure of the Basel II standards observed during the 2008 financial crisis, as well as encouraging market participants to use central clearing.The CVA may be largely passed on to end users via higher transaction costs.The impact of this charge is that it will potentially have an impact on the performance of the portfolio and the implementation date is 1 January 2014 for ZAR denominated trades.


Two ways to mitigate CVA and minimize the impact on your portfolio is through:
o Collateralisation
o Central clearing
To find out how you can create a collateral management program, join us for our practical Collateral Management course in Johannesburg on 15-16th August 2013. For more information: Visit:www.hedgefudacademy.co.za

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Regulatory update: Impact of CVA for hedge funds, pension funds, asset managers and corporates.

  1. 1. For further discussion or information about the coverage of CVA at our 5 – 6 August 2013 conference, please call Yvonne van Wyk or Marilyn Ramplin on 011 783 9390 or email yvonne@hedgefundacademy.co.za. Vat No: 4560 261 069 CVA due date Jan 2014 - Implication for Hedge Funds, Corporates, Asset Managers and Pension Funds Credit Valuation Adjustment Under the current Basel II standards, banks are subject to a capital charge primarily to cover the losses arising from the actual default of a counterparty of an over-the-counter (‘OTC’) derivative contract. Under the proposed Basel III framework, the capital charge will be enhanced by a new charge, called the Credit Valuation Adjustment (‘CVA’) Risk Capital Charge. This is a capital charge, whereby the bank is required to hold additional capital when entering an OTC trade. The charge is designed to cover losses arising from the fact that as the counterparty’s financial position worsens, the market value of its derivatives obligation declines1, even though there might not necessarily be an actual default. The charge incentivises hedging, a failure of the Basel II standards observed during the 2008 financial crisis, as well as encouraging market participants to use central clearing. As currently drafted, the CVA risk capital charge when using OTC derivatives will be greater for trades with any of the following characteristics: 1. Long dated derivatives: CVA considers the entire life of the derivatives exposure. 2. Directional risk profiles: CVA is based on the net exposure to a given counterparty. 3. Uncollateralized exposures: An input to the CVA calculation is the size of the expected uncollateralized mark to market values. Posting daily collateral reduces the charge substantially. 4. Low rated counterparties: Higher probability of default results in a higher CVA charge. 5. Counterparties with no liquid CDS market: A capital charge reduction is allowed where counterparty exposure is reduced through the use of a CDS contract. Introduction The South African Reserve Bank (SARB) will implement the proposed Basel III standards on capital and liquidity for all banks in SA. The Basel III rules seek to raise both the quality and quantity of the regulatory capital base and incentivise clearing through higher capital requirements on un-cleared positions. Although the capital requirements do not apply directly to hedge funds, pension plans and investments managers, the increased cost imposed on investment banks for their derivatives business is likely to be, at least in part, passed on to end users through higher transaction costs. Given this list of characteristics, it is clear that the typical trades that are transacted by hedge funds, pension funds and asset managers may attract particularly large CVA risk capital charges. Most fixed income funds are already experiencing the impact of CVA.
  2. 2. For further discussion or information about the coverage of CVA at our 5 – 6 August 2013 conference, please call Yvonne van Wyk or Marilyn Ramplin on 011 783 9390 or email yvonne@hedgefundacademy.co.za. Vat No: 4560 261 069 How to mitigate the CVA charge:  Collateralisation  Central clearing Collateralisation Collateral where the threshold is zero and low minimum transfer amounts will have better treatment, but collateral does not eliminate all counterparty risk and therefore the CVA charge will not disappear. Many firms are under pressure from their banking counterparts to collateralise their trades. The process of collateralisation is new to many buyside institutions and has left many firms with severe challenges around legal, fund structure, regulatory, operational, risk and liquidity issues. The impact of CVA is, however, real for a number of managers and will impact the performance of their portfolio. Central Clearing Clearing is a post-execution process in which an independent third party – central clearing counterparty (“CCP”) or clearing house – steps in between the original parties to a derivatives transaction and guarantees the performance of both parties. The clearing house “becomes the buyer to every seller and the seller to every buyer”, through a process known as “novation”. Trades that are cleared through a central counterparty (‘CCP’) will be collateralized daily, reducing any potential CVA charge. In a centrally cleared model, counterparty risk is reduced by each end investor facing a clearing member, and in turn the member faces the CCP. The exposure that the clearing member has to the client is identical to the exposure it has to the CCP, effectively passing through’ the client’s counterparty risk to the CCP. Counterparties who previously did not have to post collateral (variation or independent amount) will now have to post collateral. The CCP does not distinguish between the risk of the counterparties, but calculates margin based on the risk of the product. This could result in liquidity concerns for some funds where this has not been managed properly or the fund is new to posting collateral. In SA we don’t currently have a CCP, but the Financial Markets Act makes provision for the creation of a CCP. Costs The CVA charge is levied directly in relation to an investment bank’s balance sheet and it is expected that at least some (if not all) of this cost will be passed on to end investors. Due to the fact that the charge is levied on a net basis, it is difficult to estimate the impact of an additional trade without prior knowledge of the risks already on the balance sheet. When a trade is added to the balance sheet of the bank, a capital provision will be made, effectively ‘locking up’ this amount of capital. The charge that could be passed on to the fund (in the form of increased transaction cost) will be related to the ‘opportunity cost’ of that inactive capital; the size of Summary  The combination of Basel III and SA G20 commitments seeks to implement the regulation to create an efficient and safe derivatives market.  Basel III brings new rules in four areas o capital quality o capital requirements o leverage ratios o liquidity ratios  The impact of the Lehman Brothers collapse was also seen as another driving force behind reform.  The effect on banks will be to increase the capital they have to keep as a provision for the deterioration of the credit worthiness of trading counterparties.  The charge that is levied, the Credit Valuation Adjustment (CVA) Risk Capital Charge, may be largely passed on to end users via higher transaction costs. The impact of this charge is that it will potentially have an impact on the performance of the portfolio.  In general these costs will probably be higher for bilateral, long-dated, uncollateralized derivatives.  The SARB has pushed out the implementation date for ZAR denominated trades to end of Dec 2013
  3. 3. For further discussion or information about the coverage of CVA at our 5 – 6 August 2013 conference, please call Yvonne van Wyk or Marilyn Ramplin on 011 783 9390 or email yvonne@hedgefundacademy.co.za. Vat No: 4560 261 069 the provision and the bank’s target return on capital. How we can help: Advisory service We offer an advisory service to help you structure you collateral agreements with your counterparties and implement a collateral management framework to reduce your CVA charge. Training The Hedge Fund Academy runs regular in-house and bespoke courses on Collateral Management, CCP and Regulations. For more details visit www.hedgefundacademy.co.za Contact : Marilyn Ramplin Tel: 011 783 9390 marilyn@hedgefundacademyco.za •An additional risk based capital charge (‘CVA’) for non-centrally cleared/bilateral trades - capital charge is intended to cover risk associated with the deterioration in the creditworthiness of a counterparty What is changing? •An additional capital charge will make bilateral derivative trading more capital intensive for banks. The impact on capital requirements will be greater for exposures that are: uncollateralized, with low rated counterparties, long maturity and directional. Bilateral derivative trades will require counterparties to post variation margin and may require counterparties to post initial margin. Comments •Some of all this cost incurred by banks is likely to be passed on to hedge funds, pension funds, corporates and asset managers. •Potentially significantly impact funds with long-dates interest rate and inflation exposures or funds in the LDI space. •Bilateral derivative trades will be more capital intensive than they are today and could affect the performance of your funds. How it may impact you •Collateral Management with the correct parameters to reduce counterparty risk •CCP which would eliminate counterparty risk and therefore the charge, but currently we don't have a CCP for OTC derivatives. Ways to reduce your CVA •The planned implementation date for CVA for ZAR denominated trades is January 1, 2014. Timeline

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