WHITE PAPERHoW THE CREdIT CRIsIs HAs CHAngEdCounTERPARTy RIsK mAnAgEmEnTAuthored by David Kelly (Quantifi)•   Current tren...
ABout the AuthorDavid Kellydavid Kelly, director of Credit Products, Quantifi, brings almost 20years of experience as a tr...
IntroDuctIonThe credit crisis and regulatory                     CVA desks haveresponses have forced banks tosubstantially...
Before cVA DesKsCVA desks or specialized risk control              charges are based on an internal qualitative and       ...
While counterparty risk is managed through                “To establish a basis forreserves in this example, the market ri...
cVA DesKsone of the drivers for CVA desks was                   default swap (CCds). The CVA charge is passed             ...
“With the increased capital charges for counterpartydefault risk under Basel lll and the new CVA VaR charges, there is eve...
cleArIngThe predominant issues with CVA                       not all trades can or will be cleared.                      ...
“Counterparty risk is virtually eliminated becausethe exposure is fully collateralized and ultimately backed       by the ...
DAtA AnD technology chAllengesReliable data feeds that facilitate                   crisis, such as wrong-way risk. Regula...
sensitivities for hedging purposes. Hedges                         the simulation engine would upload currentbooked by the...
ABouT QuAnTIFIQuantifi is a leading provider of analytics, trading and risk management software for theglobal oTC markets....
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Quantifi whitepaper how the credit crisis has changed counterparty risk management

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This paper will explore some of the key changes to internal counterparty risk management processes by tracing typical workflows within banks before and after CVA desks, and how increased clearing due to regulatory mandates, affects these workflows. Since CVA pricing and counterparty risk management workflows require extensive amounts of data, as well as a scalable, high-performance technology, it is important to understand the data management and analytical challenges involved.

• Current trends and best practices
• Key data and technology challenges

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Quantifi whitepaper how the credit crisis has changed counterparty risk management

  1. 1. WHITE PAPERHoW THE CREdIT CRIsIs HAs CHAngEdCounTERPARTy RIsK mAnAgEmEnTAuthored by David Kelly (Quantifi)• Current trends and best practices• Key data and technology challengeswww.quantifisolutions.com
  2. 2. ABout the AuthorDavid Kellydavid Kelly, director of Credit Products, Quantifi, brings almost 20years of experience as a trader, quant, and technologist to Quantifi.He has previously held senior positions at some of the largest financialinstitutions including Citigroup, JPmorgan Chase, AIg and CsFB.At Citigroup, he was the senior credit trader on the global Portfoliooptimisation desk, responsible for actively managing the credit risk inderivatives positions. Prior to this, he ran the JPmorgan Chase globalAnalytics group, where he was responsible for front-office pricing modelsand risk management tools for the global derivatives trading desksincluding the firm’s first CVA system. An enrolled member of the society of Actuaries, mr.Kellyholds a B.A. in economics and mathematics from Colgate university and has completed graduatework in mathematics at Columbia university and Carnegie mellon.
  3. 3. IntroDuctIonThe credit crisis and regulatory CVA desks haveresponses have forced banks tosubstantially update their counterparty been developed inrisk management processes. response to crisis-drivennew regulations in the form of Basel III, the regulations for improveddodd-Frank Act in the u.s. and Europeanmarket Infrastructure Regulation (EmIR) have counterparty riskdramatically increased capital requirementsfor counterparty credit risk. In addition to management. How doimplementing new regulatory requirements,banks are making significant changes to internal these centralized groupscounterparty risk management practices. differ from traditionalThere are three main themes inherent in these approaches to managechanges. First, better firm-wide consolidated riskreporting has become a top priority. second, counterparty risk, andcentralized counterparty risk managementgroups (CVA desks) are being created to more what types of data andactively monitor and hedge credit risk. Third,banks are making significant investments in analytical challenges dotechnology to better support the firm-wide risk they face?reporting and CVA desk initiatives.This paper will explore some of the key changesto internal counterparty risk managementprocesses by tracing typical workflows withinbanks before and after CVA desks, and howincreased clearing due to regulatory mandates,affects these workflows. since CVA pricing andcounterparty risk management workflows requireextensive amounts of data, as well as a scalable,high-performance technology, it is important tounderstand the data management and analyticalchallenges involved.
  4. 4. Before cVA DesKsCVA desks or specialized risk control charges are based on an internal qualitative and quantitative assessment of the credit quality ofgroups tasked with more actively the counterparty by the bank’s credit officers.managing counterparty risk arebecoming more prevalent, since banks The credit portion of the charge is for thethat had them generally fared better expected loss, i.e., the cost of doing business with risky counterparties. It is analogous to CVA,during the crisis. except that the CVA is based on market implied inputs, including credit spreads, instead ofTo establish a basis for comparison, it is historical loss norms and qualitative analysis.important to review counterparty credit riskpricing and post-trade risk management before The capital portion is for the potential unexpectedthe advent of CVA desks. The case where a loss. This is also referred to as ‘economic capital’,corporate end-user hedges a business risk which traditionally has been based on historicalthrough a derivative transaction provides a experience but is increasingly being calculateduseful example. with market implied inputs. These charges go into a reserve fund used to reimburse trading desks forThe corporate treasurer may want to hedge counterparty credit losses and generally ensurereceivables in a foreign currency or lock in the the solvency of the bank.forward price of a commodity input. Anothercommon transaction is an interest rate swap The trader on the desk works with the riskused to convert fixed rate bonds issued by the control group, which may deny the transactioncorporation into floaters to mitigate interest if the exposure limit with that particular “Banks are making significant investment in technology to better support the firmwide risk reporting an CVA desk initiatives.”rate risk. In all of these cases, the corporate counterparty is hit. otherwise, it provides thetreasurer explains the hedging objective to the credit and capital charges directly or the toolsbank’s derivatives salesperson, who structures to allow the trader to calculate them. The riskan appropriate transaction. The salesperson control group also provides exposure reportsrequests a price for the transaction from and required capital metrics to the bank’sthe relevant trading desk, which provides a regulator, which approves the capital calculationcompetitive market price with ‘credit’ and methodology, audits its risk management‘capital’ add-ons to cover the potential loss processes and monitors its ongoing exposure andif the counterparty were to default prior to capital reserves according to the Basel guidelines.maturity of the contract. The credit and capital
  5. 5. While counterparty risk is managed through “To establish a basis forreserves in this example, the market risk ofthe transaction is fully hedged by the desk comparison, it is importanton exchanges or with other dealers. If thetransaction is uncollateralized, the bank’s to review counterparty credittreasury provides funding for what is effectively risk pricing and post-tradea loan to the customer in the form of a derivativeline of credit. some portion of the exposure risk management before themay also be collateralized, in which case thereare additional operational workflows around advent of CVA desks.”collateral management. counterPArty rIsK WorKfloW Before cVA DesKs Corporate Treasury Derivatives Transaction Bank Derivative Sales Derivatives Pricing Bank Treasury (funding) Funding Derivatives Trading Desk Market Exchanges & Dealers Risk Credit & Capital Reserves Collateral Collateral Management Risk Risk Control Regulatory Capital & Reporting Bank Regulator
  6. 6. cVA DesKsone of the drivers for CVA desks was default swap (CCds). The CVA charge is passed on to the external corporate customer by addingthe need to reduce credit risk, i.e., free a spread to the receive leg of the trade. unlesscapacity and release reserves, so banks the CVA is fully hedged, which is unlikely, thecould do more business. spread charged to the customer should also include some portion of economic capital toIn the late 1990’s and early 2000’s, in the wake of account for CVA VaR and potential unexpectedthe Asian financial crisis, banks found themselves loss from default.near capacity and were looking for ways toreduce counterparty risk. some banks attempted since credit risk spans virtually all asset classes,to securitize and re-distribute it, as in JPmorgan’s the CVA desk may deal with multiple internalBistro transaction. Another approach was to trading desks. The risk control group treats thehedge counterparty risk using the relatively new CVA desk like other trading desks, imposingCds market. trading limits and monitoring market risks using traditional sensitivity metrics and VaR. The CVAThe recent international (2005) and u.s. (2007) desk executes credit and market risk hedges onaccounting rules mandating the inclusion of CVA exchanges or with other dealers and relies on thein the mark-to-market valuations of derivatives bank’s internal treasury to fund positions. To thepositions provided additional impetus for more extent the CVA desk attempts to fully replicateprecisely quantifying counterparty risk. some (hedge) CVA, while the derivatives desks alsobanks attempted to actively manage counterparty hedge the underlying market risks, there may berisk like market risk, hedging all the underlying some inefficiencies due to overlapping hedges.risk factors of the CVA. given the complexity ofCVA pricing and hedging, these responsibilities The key innovation introduced by CVA desks ishave increasingly been consolidated within quantifying and managing counterparty creditspecialized CVA desks. now, with the increased risk like other market risks, instead of relyingcapital charges for counterparty default risk under solely on reserves. The main challenge is that notBasel III and the new CVA VaR charges, there is all CVA risk can be hedged due to insufficienteven more incentive to implement CVA desks. Cds liquidity and unhedgeable correlation and basis risks. Therefore, some reserve-based riskWith a CVA desk, most of the trading workflow management is unavoidable. Based on trendsis the same except the CVA desk is inserted among the top-tier banks, the optimal solutionbetween the derivatives trading desks and the involves hedging as much of the risk as possible,risk control group. Instead of going to the risk considering the cost of rebalancing hedges incontrol group for the credit and capital charges, a highly competitive CVA pricing context, andthe trader requests a marginal CVA price from then relying on experienced traders well-versedthe CVA desk, which basically amounts to the in structured credit problems to manage theCVA desk selling credit protection on that residual exposures.counterparty to the derivatives desk. This is aninternal transaction between the two desks,which can be in the form of a contingent credit
  7. 7. “With the increased capital charges for counterpartydefault risk under Basel lll and the new CVA VaR charges, there is even more incentive to implement CVA desks.” counterPArty rIsK WorKfloW WIth cVA DesK Corporate Treasury Derivatives Transaction Bank Derivative Sales Derivative Pricing Bank Treasury (funding) Funding Derivatives Trading Desk Market Exchanges & Dealers Risk Marginal CVA Price Funding CVA Desk Credit Risk Exposure Limits Collateral Collateral Risk Risk Control Management Regulatory Capital & Reporting Bank Regulator
  8. 8. cleArIngThe predominant issues with CVA not all trades can or will be cleared. Clearinghouses will only be able to handledesks are that they insert another standardized contracts and the dodd-Frank andoperational layer into the workflow and EmIR regulations specifically exempt corporateadd substantial analytical complexity. end-user hedge transactions from mandatory clearing, so that banks can continue to provideCVA models have to incorporate all the market credit lines and risk transfer services throughrisk factors of the underlying derivative plus derivatives. It is estimated that at least a quarterthe counterparty credit risk. Even the CVA on a of derivatives transactions will remain oTC,plain vanilla FX forward is complex because the which means banks will need to maintain bothcounterparty effectively holds an American-style CVA and clearing workflows.option to default. In addition to the option riskprofile, the CVA trader must also consider thecorrelation between the counterparty’s default “Transactions are assignedprobability and the underlying market riskfactors, i.e., ‘wrong-way risk’. or novated to themargining formulas are much simpler than clearinghouse, whichCVA and economic capital models, and new becomes the counterpartyregulations are either mandating or heavilyincentivizing banks to clear or fully collateralize to both sides of the trade.”derivative transactions. In cleared transactions,the clearinghouse effectively replaces the CVAdesk in the workflow. Transactions are assignedor novated to the clearinghouse, which becomesthe counterparty to both sides of the trade.Counterparty risk is virtually eliminated becausethe exposure is fully collateralized and ultimatelybacked by the clearinghouse and its members.There is a remote risk that the clearinghouse failsbut the risk control group can focus on relativelysimpler issues like collateral management,liquidity, and residual market risks. since clearedtransactions are fully margined, the CVA charge isreplaced by the collateral funding cost, which istypically based on an overnight rate.
  9. 9. “Counterparty risk is virtually eliminated becausethe exposure is fully collateralized and ultimately backed by the clearinghouse and its members.” counterPArty rIsK WorKfloW WIth cleArIng Corporate Treasury Derivatives Transaction Bank Derivative Sales Derivatives Pricing Bank Treasury (funding) Funding Derivatives Trading Desk Market Exchanges & Dealers Risk Collateral Funding Cost Collateral Funding Credit Clearinghouses Management Risk Control Risk Regulatory Capital & Reporting Bank Regulator
  10. 10. DAtA AnD technology chAllengesReliable data feeds that facilitate crisis, such as wrong-way risk. Regulators are continuously raising the bar in terms of modelingregular updates and data every risk factor, such as potential shifts inintegrity checks are absolutely basis spreads, volatilities and correlations. newfundamental to effective regulatory requirements for back-testing andcounterparty risk management. stress testing are designed to ensure the validity of the model.Banks typically maintain separate systems fortheir main trading desks, roughly aligned by the outputs of the simulation engine include current,major asset classes – interest rates and foreign expected and potential future exposures,exchange, credit, commodities and equities. CVA and economic capital by counterparty.since counterparty risk spans all asset classes, The system should also capture counterpartythe counterparty risk system must extract exposure limits and highlight breaches. given thetransactions, market data and reference data complexity of the inputs and outputs, a robustfrom all the various trading systems. In addition, reporting system is critical. The system shouldsupplemental reference data on legal entities allow aggregation of exposure metrics along a “The most sophisticated global banks have targetedthe CVA and clearing workflows and supporting technology infrastructure. It is expected that regional banks will follow suit over the next few years.”and master agreements may need to come from variety of dimensions, including industry andother databases. These systems typically use legal jurisdiction. The system should also allowdifferent data formats, symbologies and naming drilling down into results by counterparty nettingconventions, as well as proprietary interfaces, set and individual transactions. By extension,adding significant complexity. users should have an efficient means to diagnose unexpected results.The next set of challenges involves balancingperformance and scalability with analytical There may also be a separate system for marginalrobustness. The simulation engine may have to pricing of new trades and active management ofvalue on the order of one million transactions CVA. The marginal pricing tools need to accessover a hundred future dates and several thousand results of the portfolio simulation, since the pricemarket scenarios. depending on the size of of each new trade is a function of the aggregatethe portfolio and number of risk factors, some exposure with that counterparty. Because ofshortcuts on the modeling side may be necessary. this, calculating marginal CVA in a reasonableHowever, there are critical analytical aspects that time frame can be a significant challenge. Thecannot be assumed away given their role in the CVA risk management system provides CVA
  11. 11. sensitivities for hedging purposes. Hedges the simulation engine would upload currentbooked by the CVA desk should flow through collateral positions and revalue them for eachthe simulation engine so that they are reflected market scenario to determine net exposure. Thein the exposure and capital metrics. Whereas the simulation engine should also incorporate theCVA desk may hedge credit and market risks, ‘margin period of risk’, i.e., the risk of losses fromonly approved credit hedges, including Cds, non-delivery of collateral.CCds and to some extent credit indices, may beincluded for regulatory capital calculations. Even with the crisis-induced wave of improvements, the picture remains very complex.Cleared transactions must be fed to the The most sophisticated global banks haveclearinghouses’ systems and trade repositories. targeted the CVA and clearing workflows andsince clearing involves daily (or more frequent) supporting technology infrastructure describedmargining, the bank’s collateral management in this paper. It is expected that regional bankssystem should be integrated with the will follow suit over the next few years in order toclearinghouse. It should also be integrated optimize capital and manage risk more effectively,with the counterparty risk system. Ideally, as well as comply with new regulations. counterPArty rIsK DAtA floWs & technology InfrAstructure IR/FX Credit Commodities Equities Trading System(s) • Counterparties • Transaction • Legal Limits • Reference Data • Market Data Clearing Systems & Trade Repos CVA Risk Counterparty Exposure Collateral Management System Simulation Engine Management System Marginal CVA Pricing Tool Reporting
  12. 12. ABouT QuAnTIFIQuantifi is a leading provider of analytics, trading and risk management software for theglobal oTC markets. our suite of integrated pre and post-trade solutions allow marketparticipants to better value, trade and risk manage their exposures and respond moreeffectively to changing market conditions.Founded in 2002, Quantifi has over 120 top-tier clients including five of the six largest globalbanks, two of the three largest asset managers, leading hedge funds, insurance companies,pension funds and other financial institutions across 15 countries.Renowned for our client focus, depth of experience and commitment to innovation, Quantifi isconsistently first-to-market with intuitive, award-winning solutions.For further information, please visit www.quantifisolutions.comConTACT QuAnTIFIEuRoPE noRTH AmERICA AsIA PACIFIC16 martin’s Le grand 230 Park Avenue 111 Elizabeth st.London, EC1A 4En new york, ny 10169 sydney, nsW, 2000+44 (0) 20 7397 8788 +1 (212) 784-6815 +61 (02) 9221 0133enquire@quantifisolutions.com

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