Quantifi Newsletter InSight issue 05


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Quantifi Newsletter InSight issue 05

  1. 1. INNEWSLETTER ISSUE 05 SIGHT 2 012Calculating the Effect ofFunding Costs onOTC ValuationUsing FVAAlso in this issue:Quantifi: Ten Years OnPage 3Q&A with Shawn Stoval,Founding Partner,Varden PacificPage 6
  2. 2. Message Newsfrom Oracle Capital Extends Usage of Quantifi for OTC Risk Management andthe ceo Regulatory Reporting “Delivered through an intuitive and flexible user interface, Quantifi’s market leadingThis year marks an important milestone for Quantifi as we pricing, risk management and datacelebrate 10 years of business. Our journey began in 2002 capabilities provides our firm with thewith one other employee in a small attic in New Jersey after necessary tools to support the growingpreviously heading Citi’s global credit derivative and emerging demands of our business. I’ve beenmarket trading research groups. Quantifi was started with the particularly impressed with the sophisticationgoal of delivering the same sophisticated risk management and of Quantifi’s reporting tool as it providesanalytics used by the largest banks to all market participants. timely, transparent and consolidated riskThe timing proved fortuitous and Quantifi grew along with the reporting which helps to significantly enhancebroader OTC markets. We have come a long way since then, our risk control process.” Leon Hindle, Chiefhaving expanded our footprint in EMEA, NA and Asia and Investment Officer, Oracle Capital.established a brand that is now synonymous with a commitmentto innovation and a strong passion for what we do. Our goals, Quantifi Releases Support forhowever, remain the same – to deliver the most advanced risk Calculating the Effect of Fundingmanagement and analytics available for the OTC markets and Costs on OTC Valuation Using Fundingto provide our clients with intuitive, flexible solutions that Valuation Adjustment (FVA)match their needs. “The cost of funding has become a significant topic for financial institutions as it is regardedWe talk to many different institutions and whilst risk as a key component in analysing the expo-management is uniformly seen as an increasingly important sures and profitability of a trade. FVA is thediscipline, there remains a wide divergence in risk management latest market innovation that has rapidlypractices. Managing market, funding, regulatory, liquidity, become the standard for measuring this cost.operational and other risks involves the business model and Our support for FVA continues a long trackrisk appetite of a firm and needs to come from the board down. record of partnering with clients to deliver so-This is a huge change from even a few years ago and one that lutions that give them a competitive edge bymany firms have yet to embrace. The significant increase in more accurately valuing and measuring theircomplexity of all aspects of risk management raises the bar risks.” Rohan Douglas, CEO, Quantififor risk specialists but presents a unique opportunity. As firmsrevisit their risk management infrastructure in an environment Quantifi Teams Up With Thomson Reuterswhere they are increasingly concerned about return on capitaland business flexibility, the case for external solutions becomes “Quantifi is dedicated to providing clients withcompelling for systems that do not represent IP that clearly a seamless interface to popular data providersprovides a competitive advantage. The challenge for providers and we are very excited about this latest initia-is the ability to match the required level of sophistication and tive of providing easy access to pricing datastay ahead of the rapid pace of market evolution. This is an from Reuters DataScope. Our recent releaseenvironment that Quantifi’s strengths shine. We have a long of Version 10.2 included expanded data man-track record of delivering sophisticated, flexible and intuitive agement capabilities with out-of-the-box datasolutions that reduce our clients operational costs and increase interfaces designed to simplify connectivity”their business flexibility while providing first-to-market support Rohan Douglas, CEO, Quantififor the latest market innovationsAs a final note, I’d like to take this opportunity to congratulatethe Quantifi team on their accomplishments, their commitment EVENTSto innovation and their continued passion in our business. I also Quantifi Seminar: The Evolution ofwant to thank our clients and friends for their continued, equally Counterparty Risk in the German Bankingpassionate, support. Industry – Frankfurt, May 24th Quantifi Webinar: Managing the Complexities of CVA, DVA and FVA – May 30th For more information, visit:ROHAN DOUGLAS, Founder and CEO www.quantifisolutions.com/events.aspx02 | www.quantifisolutions.com
  3. 3. T I F I S OL AN UQuantifi: QU TI ONS TEN Ten Years on TH Y AN R A NIVERSBy constantly innovating and turning new ideas into As we continue to grow a robust and sustainablepioneering solutions, Quantifi has over the past business our exceptional products and services,ten years established itself as a leading provider of depth of experience and outstanding customeranalytics and risk management software for the service distinguishes us from our competitorsglobal OTC markets. Thank you to all ourTen Ways We’re Different clients  and  friends forExperience1.  Quantifi has a unique depth of experience in the their continued support.OTC markets. Our executive team has on average over Rohan Douglas, CEO, Quantifi20 years of experience leading research and trading attop-tier global banks including JP Morgan, GoldmanSachs, and Citi.Innovation 10/10 – Full Marks From Clients2. As a result of our long-term, on-going investment in 1. “Quantifi has already reduced our operational costsR&D combined with close partnerships with our clients, and increased our business flexibility by allowing us toQuantifi is consistently first to market with leading, focus internal development on other strategic projects.”innovative solutions.3. We constantly seek inventive ways to improve what 2. “Sophisticated pricing models, un-matched assetwe do and how we do things, ensuring we best serve coverage and an intuitive interface were all key driversthe needs of our clients. behind CM-CIC’s decision for choosing Quantifi.”4. As early adopters of key technologies including 3. “Quantifi came highly recommended, and webeing the first commercial native .NET analytics library have been very impressed with the breadth andand the first vendor to support the Intel TBB multi-core sophistication of the product. We were able to get upAPI gives our clients advantages in terms of speed, and running immediately, which allowed us to rapidlyscalability, and usability. scale our business.”Analytics 4. “Our decision to choose Quantifi Risk was based on5. A recognised leader for fast, accurate analytics for a its relatively short implementation time, ease of use andbroad range of OTC products broad functionality.”6. With our commitment to innovation we continue to 5. “Quantifi XL is now considered to be an integralbreak new ground, ensuring our clients remain ahead of component within our structured credit business andthe rapidly changing OTC markets. has allowed us to enhance the manner in which weTrusted monitor and control our risk.”7. The world’s most sophisticated financial institutions 6. “Valuation and risk management are key componentsincluding five of the six largest global banks, two of the in everything we do, and it became clear that Quantififour largest asset managers, leading hedge funds and was the best fit for our business.”insurance companies, trust Quantifi to help them better 7. “Quantifi is a recognised market leader in this spacevalue, trade and risk manage their exposures. and had come highly recommended.”Commitment 8. “We are continually impressed at the speed at which8. Our long-term incentives are aligned with those of Quantifi can enhance their products to keep up with theour clients. rapidly changing markets.”9. By constantly innovating and turning new ideas intopioneering solutions, we continue to exceed our client’s 9.  “The models are robust and the level of productexpectations. support and assistance in development from Quantifi is of the highest order.”10. Our commitment to integrity, quality and inno-vation enables us to deliver superior products that are 10. “In essence, employing Quantifi provides anintuitive, flexible, and integrate seamlessly into additional element of competence and confidence inexisting processes. the active management of our portfolios.” www.quantifisolutions.com | 03
  4. 4. cover story Calculating the Effect of Funding Costs on OTC Using FVA Background The implementation of new regulations including impact of funding and liquidity on the value of a Dodd-Frank, MiFID II, EMIR and Basel III is significantly trade. This value depends on the nature of the CSA increasing the cost of capital and forcing banks to (collateralised, uncollateralised, or asymmetrical) and the re-evaluate the economics of their OTC trading net collateral posted or received. businesses. McKinsey in their working paper “Day of Collateralised Swap Case reckoning? New regulation and its impact on capital- markets businesses” ¹, estimates the average return on Consider a single collateralised swap between two equity (ROE) of OTC businesses will go from 20% to 7% counterparties Bank A and Bank B. Under terms of the post regulation. CSA, as the market value of the swap changes, collateral is posted or is received. Market best practice implemented by the most sophisticated banks now accurately measures all the Negative Mark to Market components of a trade to analyse its profitability If the mark to market of the swap is negative under including Credit Valuation Adjustment (CVA), the Cost terms of the CSA, the bank must borrow funds to post of Regulatory Capital (CRC) and most recently Funding as collateral. These funds will be borrowed at the bank’s Valuation Adjustment (FVA). unsecured borrowing rate. Accurately measuring these components requires tak- The collateral posted will earn an interest rate specified ing into account the OTC trades done across all desks by the CSA, which will typically be Fed Funds in the US, with that counterparty, along with the collateral posted and the OIS rate in Europe. or received as part of any CSA. This is a significant new Positive Mark to Market challenge for OTC businesses that has traditionally If the mark to market of the swap is positive the bank will been siloed with often-separate front office analytics receive collateral from its counterparty. This collateral and systems. typically will only earn the CSA rate, which is what will be As these components span multiple trading desks, paid to the counterparty. there has been a trend towards central measurement The asymmetric nature of funding adds an additional and management of these components by CVA desks cost to the swap. with various strategies for allocating the P/L and risk of a trade between each trading desk and the CVA desk. Portfolio FVA The above example for a single swap is clear but Funding Valuation Adjustment (FVA) unrealistic. Typically there will be a range of trades The Funding Valuation Adjustment (FVA) is the latest across different asset classes. If we consider the case of significant innovation in this area and captures the a portfolio of swaps traded between two counterparties¹ cKinsey Working Paper “Day of reckoning? New regulation and its impact M on capital-markets businesses”, September 2011 04 | www.quantifisolutions.com
  5. 5. under a single CSA (or netting agreement), it can be looking at the various CSA structures. These differences,seen that the cost of funding is based on the net mark to along with the existence of alternate approaches andmarket for all swaps with that counterparty. levels of sophistication for modelling wrong-way risk, result in differences in valuing FVA. When FVA is takenAnalogous to CVA, accurately calculating the effect of in the context of trade profitability, these differences arethis asymmetrical funding cost or FVA requires taking not a significant issue and as modelling becomes moreinto account all OTC trades with a counterparty along sophisticated are likely to converge.with the terms of the CSA. Valuation for FVA should take into account all kindsPricing Versus Profitability of dependencies: between Bank credit and tradeFrom the single swap example above, it can be seen PV, between Counterparty credit and trade PV,that the two counterparties will not agree on a price and between credit themselves. Ignoring theseif funding costs differ - even if both share similar dependencies can lead to significant mispricing of FVA,counterparty risk (and CVA). FVA is more appropriate and thus trade profitability.in the context of measuring the profitability of a traderather than as part of a mark to market calculation.Uncollateralised Swap CaseNext, consider a single uncollateralised swap between a ‘The introduction of FVA is onebank and a client, hedged with an offsetting trade with a further step towards a significantcentral clearing counterparty (CCP).For the uncollateralised swap, no collateral is posted restructuring of the way OTCor received. If the swap is hedged with a counterpartywhere collateral is posted with a CCP the cost of the businesses are managed.’hedge will include the FVA. It may be natural for thebank to allocate this cost to the client’s swap.Challenges ConclusionCalculating FVA presents significant modelling, The cost of funding has become a significant topicorganisational, and infrastructure challenges. Many of for financial institutions as it is regarded as a keythese challenges are shared with CVA so FVA provides a component in analysing the exposures and profitabilitynatural extension for CVA processes and systems. of a trade. FVA is the latest market innovation that has rapidly become the standard for measuring this cost.OrganisationFVA is one measure included in trade profitability. The FVA is the latest in a triad of valuation adjustmentsallocation and management of this component presents (CVA, DVA, FVA) which has to be taken into accountsignificant organisational challenges. Banks adapt with when profitability of the trade is estimated. Unlikeseveral common alternate structures depending on the CVA, it is the cost which cannot be passed to thenature of their business and their size. counterparty, therefore knowing it is imperative for successful management of the trading book. Value ofSome more common alternative structures include: the FVA charge is proportional to the funding cost of • VA P/L and risk allocated and managed by a central F the bank, therefore banks with higher funding spread CVA desk. (i.e. worse credit) end up losing trades and become less competitive. • VA P/L and risk allocated and managed individually F by desks with central oversight and infrastructure. The introduction of FVA is one further step towards • VA P/L and risk allocated and managed by each F a significant restructuring of the way OTC businesses desk on an ad-hoc basis. are managed. These changes are having a profound effect on the organisational structure, analytics, and riskInfrastructure management systems of OTC businesses, a trend that willFVA, like CVA presents significant infrastructure continue as more banks adapt to the new market reality.challenges. All trades with a given counterparty needto be valued from both a market perspective and acredit perspective. All of a banks OTC trades need tobe combined along with market data, credit data, legaldata and collateral.ModellingThe concepts and motivations behind FVA arestraightforward but there remains confusion anddifferences about its application and how it relates toother components of OTC valuation including CVA, DVAand CSA discounting. This is particularly the case when www.quantifisolutions.com | 05
  6. 6. Q and FEATURE What is the history and background of your company? spreads, one has to take in to consideration a number of factors. In addition to actual default risk, market observedVarden Pacific LLC is a San Francisco based investment credit spreads also incorporate a liquidity premium andmanager that was founded in 2010, launched its flagship some degree of counterparty risk in synthetic credit. Afund in April 2011 and currently manages over $200 million very low interest environment can also dictate the amountin its core strategy. Varden is focused on capitalizing on of absolute yield that an investor is willing to receive forniche opportunities and residual dislocations within the taking term credit risk, thus increasing the spread relativestructured credit markets, specifically within corporate- to the risk-free rate of return. These factors, however,backed structured credit. The firm’s strongly held view diverge from fundamental analysis when determining theis that for the near to medium term, corporate defaults/ propensity of a given company to default within a specificbankruptcies in Fortune-500 type companies will not time period. This disconnect has created significantexceed the levels realized during 2008/2009 – the worst opportunities for deploying risk capital in structured creditsince the Great Depression. A number of fundamental products where corporate defaults are the only factor infactors support this view including; cash on corporate determining the ultimate return on investment.balance sheets reaching a 20 year high, a low interest rateenvironment, strong free cash flow generation, access to hat key challenges and/or opportunities does the Wcapital markets, a lack of near term debt maturities and a current environment bring to your business and howslowly improving economy. do you intend to manage them? ver the course of the past 12 months what do you O The capital market climate for corporations, especially consider to be the most significant development in domestically, continues to be constructive. A key driver the OTC markets? to this strength is the access to liquidity. Corporate debt issuance in the second half of 2011 was extremelyCredit markets over the last 12 months have experienced challenging. In 2012, however, we have seen corporatea material disconnect between the market implied debt issuance return to historic highs.The total amountprobability of default as calculated from credit spreads of high yield debt issued in 2012 is roughly equal toand the probability of default as determined from the amount of high yield bond and loan debt that isfundamental analysis of balance sheet health, free cash maturing in all of 2012 and 2013. The looming “wall offlow from operations and near term debt maturity profile. debt” that has been a common conversation over theThroughout 2011 and in to 2012, investment grade and last three years continues to be pushed further into thehigh yield credit spreads are predicting a five year high future. Equally important to the amount of debt that isyield environment that is a multiple of what occurred being issued is how the proceeds are being used. So farduring the Great Depression. When analysing credit this year, approximately 60% of all proceeds have been06 | www.quantifisolutions.com
  7. 7. A “As a point of reference, to become Basel III compliant, European banks are faced with the dilemma of raising $ 450 billion of equity capital or selling 17% of risk weighted  assets – a staggering $ 5 trillion of assets.” interview with Shawn Stoval, Founding Partner, Varden Pacificused to refinance existing high yield debt. This is a major housing and manufacturing is signaling an upturn.sea change from 2008 when almost 50% of all debt Industrial production is firming, oil prices have easedproceeds was used to finance MA and LBO activities. and the Federal Reserve continues to take a “wait andCorporate CFO’s have “found religion” following see” stance towards additional easing. We are boundthe results of their pre-Crisis actions. This change in to see bouts of volatility throughout the rest of the yearphilosophy has had a significant impact on lowering the as markets attempt to predict the potential impact of arate of corporate defaults. Greek departure from the Euro. That being said, with the first quarter now behind us, the majority of domestic hat is your reaction to the changing regulatory W corporations have either met or exceeded performance landscape. How will it impact your business? expectations. The current landscape remains constructiveChanges in the regulatory capital environment, especially for emerging funds like Varden Pacific who have thethe increased scrutiny regarding European banks, nimbleness and expertise to monetize a tailored creditcontinue to dictate the ability of investors to remain in their view in a careful and experienced manner.legacy structured credit positions. These changes areforcing original holders to purge capital inefficient assetsfor non-economic purposes. Looking forward, we expectthis forced selling to continue. As a point of reference, tobecome Basel III compliant, European banks are facedwith the dilemma of raising $450 billion of equity capitalor selling 17% of risk weighted assets — a staggering $5trillion of assets. Unless sentiment shifts dramatically andbanks can raise a massive amount of equity capital costeffectively, the liquidation of capital inefficient assets willbe a secular trend over the coming years. Looking ahead, what market development do youanticipate?More generally, market sentiment has improved,especially relative to Q4 2011. The US economy continuesto decouple from Europe and is growing, albeit moreslowly and unevenly than many would prefer. At thispoint, data in a number of depressed sectors including www.quantifisolutions.com | 07
  8. 8. Risk Management WhitepapersTechnology Award • OIS and CSA DiscountingQuantifi recently achieved one • ow the Credit Crisis Has Hof the industry’s highest accolades Changed Counterpartyhaving won ‘Risk Management Risk ManagementTechnology Product of the Year’ in • hallenges in Implementing a Counterparty CRisk Magazine’s 2012 Risk Awards. Risk Management ProcessAccording to Risk Magazine (Risk, January 10, 2012):Quantifi was • volution of Counterparty Eamong the first technology suppliers to support OIS discounting, Credit Riskcredit value adjustment (CVA) – and the latter’s more controversialtwin, debit value adjustment (DVA). Quantifi cemented its reputa- • CVA, DVA and Bank Earningstion for accurate pricing with its initial credit pricing library in 2006,and has maintained the quality while branching out across other Request a copy:asset classes such as interest rates and foreign exchange. Its tech- enquire@quantifisolutions.comnology is relatively light and slots into a bank’s infrastructure quickly.Quantifi clients praise the company’s balance of business and tech-nological expertise. While a number of banks have implemented VideosQuantifi Risk on an enterprise level, it also offers a cost-effectiveoption for individual business units or smaller institutions.“We are delighted that Quantifi Risk continues to receive a high level of industry recognition. This award means a great deal to us, especially considering our size compared to other firms operating in our space,” comments Rohan Douglas, CEO of Quantifi. “With a significant commitment to research and development, combined with close collaboration with our clients, Quantifi consistently leads the industry with innovative solutions. Quantifi PRMIA teamed up to present an Winning this award from one of the premier publications in risk interactive seminar on Counterparty Risk management is testimony to this on-going commitment.” CVA where experienced practitioners discussed related matters:Partners • urrent trends in setting up CVA processes CQuantifi Teams Up With Thomson Reuters • Marginal CVA pricing practicesQuantifi’s recent strategic alliance with Thomson Reuters is • ow are banks hedging CVA now and in Hdesigned to enhance the level and accessibility of data available the future?to institutional investors. The ability to access Thomson Reuterspricing data allows Quantifi’s clients to improve decision making • Regulatory prioritiesand productivity, while increasing valuation, trade processing, View seminar videosrisk management and reporting efficiency. Quantifi clients now http://quantifisolutions.com/videos.aspxhave the ability to access data on demand, tailoring their usageto meet their needs. This enables clients to streamline operationsand costs while providing the necessary transparency around theirdata usage both in volume and asset class.ABOUT QUANTIFIQuantifi is a leading provider of analytics, trading and risk management software for the Global Capital Markets. Our suiteof integrated pre and post-trade solutions allow market participants to better value, trade and risk manage their exposuresand respond more effectively to changing market conditions.Founded in 2002, Quantifi is trusted by the world’s most sophisticated financial institutions including five of the six largestglobal banks, two of the three largest asset managers, leading hedge funds, insurance companies, pension funds and otherfinancial institutions across 15 countries.Renowned for our client focus, depth of experience and commitment to innovation, Quantifi is consistently first-to-marketwith intuitive, award-winning solutions.enquire@quantifisolutions.com | www.quantifisolutions.comEurope: +44 (0) 20 7397 8788 • North America: +1 (212) 784 6815 • Asia Pacific: +61 (02) 9221 0133Follow us on:    @ Quantifi © Quantifi Inc. All rights reserved. Quantifi, Quantifi Risk, Quantifi XL, Quantifi Toolkit, Quantifi Counterparty Risk, Quantifi CVA are trademarks of Quantifi Inc.