Spotlight on CVA: Trends, Perspectives and IT Implications

2013 CEB

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Spotlight on CVA: Trends, Perspectives and IT Implications

Dushyant Shahrawat, CFA Compliments of Numerix Senior Research Director Capital Markets

April 2013

Executive Summary Measuring counterparty exposure via Credit Value Adjustment (CVA) in the OTC Derivatives market remains a key issue for the global financial services industry. Driven by accounting requirements (IFRS 9 and ASC820), regulatory requirements (Basel III, CRD IV) and the need to better manage PnL volatility, firms are expanding CVA capability at a rapid rate. But far from being an esoteric quantitative problem, it is becoming a business issue impacting real earnings, spawning new operating models, and becoming a factor in investing and trading decisions. CEB TowerGroup research indicates that despite several years of intense focus on CVA, industry preparedness varies widely and managing counterparty exposure fully (including CVA) remains a ‘work in progress’. Capital markets firms fall all along the CVA maturity curve, starting from simple measurement and reporting of CVA, to effectively hedging CVA firm wide, and finally to CVA as a profit center. As firms migrate from one level of maturity to another, their commitment, understanding and investment in CVA (including IT and operations) grows in size and scale. As the firm’s CVA maturity grows, the firm develops a strategic IT roadmap for its CVA operations and often replaces inhouse applications and a patchwork of systems with specialized CVA applications from reputable third-party software firms that specialize in CVA. A firm’s CVA maturity also impacts the way it organizes and manages the CVA desk, as well as the technology used. At stage 3 of maturity when firms manage a CVA PnL, speed, accuracy and scalability become essential elements in addition to the demands placed by earlier stages of maturity. The two alternate approaches firms have taken in managing counterparty risk are to centralize or decentralize CVA desks, with implications for IT and operational costs and the extent of benefits from netting that the firm can realize. Neither approach is better per se though the industry seems to be slowly moving to a centralized model driven by the netting benefits that can be gained as clients trade more across asset classes. Centralized CVA desks are not easy to setup or run, they require substantial IT and infrastructure costs, significant amounts of data to be integrated across desks, and navigating thorny political issues. A lot of firms still consider CVA as a straight-forward activity to essentially calculate counterparty exposure and factor this into the pricing and management of OTC Derivatives. Thinking of it myopically as a simple ‘calculation’ exercise is a mistake. Besides the regulatory requirements and accounting rules requiring firms to measure and report CVA, greater utilization of OTC Derivatives by more firms, and employing them in ever more investment and trading strategies means firms need to have a long-term strategic view on managing CVA. This includes executive commitment to handling CVA effectively, a

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clear well-thought out CVA strategy, and the requisite investment of data, analytics and infrastructure required to perform CVA effectively. A mature, long-term view about CVA has major consequences for a firm’s capital structure, competitive positioning and ability to manage Derivatives risk. CVA remains one of the most complex and computationally demanding activities in capital markets. Calculating a CVA sensitivity for a large sell-side shop can require 10-20 million valuations that must be done cost-effectively, otherwise the hardware and infrastructure costs alone would make doing CVA hugely unprofitable. Large OTC Derivatives desks with experience in managing counterparty risk have built CVA capability on top of core OTC derivatives operations, but even they struggle to fully manage CVA. For other firms – commercial banks, insurance carriers, smaller brokers and asset managers – CVA remains a ‘work in progress’ including the daunting task of selecting data sources, pricing, analytics and valuation sources, and managing the significant infrastructure requirements involved. CVA is becoming a broader issue for financial services companies spreading beyond OTC Derivatives desks at sell-side firms, commercial banks and corporates. More firms are getting involved in CVA, most notably hedge funds and buy-side firms. Though fewer than 16-18% of buy-side firms currently measure and manage CVA, interest is growing quickly as investment managers expand their involvement with risk analytics and the newly formed Chief Risk Officer (CRO) begins focusing on enterprise-wide risk issues including CVA. Expect to see, in the next few years, buy-side firms gradually replicate some of the enterprise-wide risk practices commonplace at sell-side firms, and CVA vendors responding by selling more to investment managers.

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Current State of Risk Analytics Technology Risk analytics technology deployed today is a complicated mix of hardware, software and services, all wrapped together with data, analytics, operational processes, and risk procedures. For financial firms to create an effective, agile and powerful risk infrastructure, they need to integrate a complicated mix of applications including pricing and valuation libraries, cross-asset analytics engines, risk systems, collateral management applications, and derivatives systems. Then there are specific systems required by firms based on the particular business they are in - broker/dealers require risk systems to aggregate exposure across trading desks, insurance firms need Asset Liability (ALM) systems, while pensions funds require liability driven investing (LDI) capability. Until 2011, capital markets companies depended more on internal systems and inhouse development to address risk analytics technology needs. Over 61% of firms developed technology inhouse in 2011, while the rest bought third-party vendor systems. But times are changing quickly, and serving the growing and increasingly sophisticated needs of risk management requires specialized technology developed by dedicated vendors whose core capability is developing such technology. By 2016, we estimate that 48% of capital markets firms will use inhouse risk analytics applications and 52% will migrate fully to third-party applications. Firms that refuse to accept this reality and stick to their parochial views will find themselves at a competitive disadvantage, or in the crosshairs of regulators.

Changing Perception of Risk Analytics in Capital Markets There is a change underway in capital markets’ perception of risk analytics technology. Exhibit 1 illustrates what factors capital markets CTO’s in a CEB TowerGroup survey outlined as the most important issues for various activities across the trade lifecycle. For each trade activity, CTO’s categorized which factors they considered as the biggest driver to invest in: 1) cost efficiency, 2) functionality, 3) competitive advantage or 4) business criticality. Risk analytics was adjudged the highest score by CTO’s – 58% – for being the most business critical. Furthermore, 17% of firms considered risk analytics as a competitive advantage. Cost considerations and functional benefits were considered least important when it comes to risk analytics. Look no further for proof of the importance of risk analytics technology to capital markets. So why then do we still witness frequent risk failures, when firms consider risk analytics to be so important? The answer is that risk practices, decisions and risk strategy doesn’t obviously depend on CTO’s and the best technological intentions are overcome by a combination of bad practice and judgment, lack of executive and organizational commitment, and frankly just short-term thinking. Exhibit 1

What is the Perception Of Capital Markets CTO’s About Different Trade Lifecycle Activities?

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Source: CEB TowerGroup Budget and Spend Benchmarking Survey, Q4 2012

Current State of CVA in Capital Markets Analyzing the state of CVA in capital markets today reveals that firms fall somewhere along the CVA maturity curve (see exhibit 2). Stage 1 of the CVA ladder is occupied by firms that simply measure and report CVA, essentially for accounting and regulatory purposes. When firms reach stage 2, they begin establishing a CVA desk to hedge counterparty exposure across the firm via involvement in the CDS market. Stage 3 denotes the highest maturity when firms regard the CVA desk as a profit center and actively trade CVA. Exhibit 2

Different Stages of CVA Maturity in Global Capital Markets

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Source: CEB TowerGroup Analysis, Estimates

As firms climb the CVA maturity curve, their demands for data, analytics and infrastructure supporting CVA grows, and they invest more into it. A typical capital markets firm at stage 1 invests $10-20 million in IT and operations costs related to CVA, at stage 2 an average firm invests $15-30 million, while IT costs at stage 3 range between $25-50 million. Beyond higher IT expense, climbing the maturity curve means a shift in mindset from ‘reporting’ to ‘managing’ to ‘profiting’ from CVA. A stage 2 firm focused on hedging CVA needs to look at CVA greeks aggregated across all its counterparties. At stage 3, firms must incorporate CVA analytics into the trader’s workflow and integrate CVA into front-office and middle-office applications like order management systems and portfolio applications. CVA books need to be marked-to-market daily or in near real-time, firms must perform active hedging and enforce market risk limits. Since 2000, major Derivatives desks worldwide have built sophisticated systems and infrastructure to measure and manage potential future exposure (PFE) from Derivatives activity. Since 2008, these dealers have built applications and infrastructure on top of this that prices, hedges and trades counterparty risk (including CVA). The extent to which large sell-side firms have deployed CVA technology has depended on their motivation for doing it. So banks that trade CVA actively and manage it as a profit center, mark-to-market daily positions, pursue active hedging and enforce market risk limits. On the other hand, firms that do CVA mainly for reporting and accounting, often use approximations, calculate exposures using mark-to-market plus simple add-ons, and perform basic simulations.

How CVA Desks Are Structured; How CVA is Being Managed in the Industry During 2010 and 2011, CVA desks were popping up all over the financial services industry, especially on the sell-side where firms were setting up desks to aggregate counterparty risk across the firm, and hedge against it by purchasing CDSs. Basel III has been a major driver from a regulatory standpoint, as has

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OTC Derivatives reform (part of Dodd Frank Act and EMIR). While the creation of new CVA desks has slowed down somewhat, a growing number of firms are considering their CVA desks as profit centers rather than simply as hedging vehicles. CVA desks are a relatively new and interesting development as they have visibility over a range of asset classes and firm wide positions. However, there is no perfect organizational structure for managing counterparty exposure or CVA. So commercial banks and investment banks continue to reorganize and restructure CVA desks, and align them with corporate goals and objectives. Traders and operations staff downsized by structured products departments during 2008-2010, now man CVA desks bringing their ability to price, manage and hedge risks across multiple asset classes covering the firm’s entire OTC book. CEB research indicates that most CVA desks are still considered as a middle-office operation and often closely associated to the risk management function. During 2008-2010, a number of CVA desks were initially part of the proprietary trading operation, but that has changed with US sell-side shops divesting proprietary trading to comply with the Volcker rule. For firms that claim to manage CVA desks as profit centers, assessing profitability is tough, as it depends upon negotiating expense allocations from other departments, and charging back services offered to other desks. It is ironical that CVA desks as being considered ‘profit centers’ when their overall objective is to ‘minimize/manage risk’ and they are aligned most closely with risk management. Most firms regard CVA desks as ‘insurance’ agents that protect the firm against counterparty exposure, which means CVA is under-appreciated until there is a major market failure and the desk emerges as the firm’s white knight. Ironically, the success of CVA desks is influenced by the firm’s ability to manage complex IT issues like aggregating counterparty exposure across different front office systems, normalizing and comparing risk figures, and addressing infrastructure demands imposed by CVA. To run CVA desks successfully, desk heads have to garner significant executive support and navigate tough political issues across different lines of business, other trading desks and departments. Even at progressive firms that view CVA desks as ‘for profit’ centers, effective CVA charges are influenced by other desks that are involved, rather than the pure counterparty exposure involved. The future of CVA desks depends on several factors including future regulatory reform, the speed with which OTC Derivatives move to a centrally cleared model, the success of ‘for profit’ CVA desks, and further progress in the technology supporting CVA.

Challenges Involved in Conducting CVA The three major elements required for conducting CVA are well understood: data, applications and infrastructure. Substantial progress has been made in the applications available, and the infrastructure approaches deployed in doing CVA, but data continues to be a challenge. Exhibit 3 shows an ideal CVA system with the types of data required on the left hand side, and the activities and outputs it offers on the right hand side.

CVA requires enormous amounts of data to be collected from internal applications across the trade lifecycle, and integrate that with external sources. Common data requirements include market data, legal entity information, default probabilities and recovery rates, trade details, credit limits and collateral agreements. The coordination required across the firm, and integration of this data remain major

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obstacles in conducting CVA and other types of risk analysis. Aggregating counterparty exposure that resides in silos across trading desks and LOB (pre-trade, post trade, risk, compliance) makes it a complicated problem. The scenarios to be considered are huge, including market data inputs and other forms of unstructured/social data. Exhibit 3

An Ideal CVA System with Major Inputs, and Outputs Coming Out Of It

Source: Counterparty Credit Risk and CVA, 2012

Until the financial crisis, demand for CVA applications/software was limited due to relatively stable bank credit spreads which didn’t cause shifts in counterparty exposure. All that suddenly changed in 2008 and since then, counterparty exposure and CVA management have become important issues with serious consequences for firm profitability, competitive standing and regulatory compliance. Consequently, vendors have built new CVA applications, repurposed older applications to perform CVA, and firms that offered ancillary functionality have begun focusing on CVA. But five years is a relatively short time for CVA technology to mature, and vendors continue to expand functionality in response to the following factors:

Demands to increase the frequency of doing CVA and move it ever closer to as real-time as possible

Incorporating it more fully into the investment decision-making and trading process so it can be a major factor in the pretrade decision itself

Changing regulatory rules, expectations and regional interpretations of CVA that impose new functional requirements on vendor solutions

Increasing levels of accuracy demanded by users considering the high stakes involved in accurately estimating CVA

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The infrastructure required to do CVA includes substantial amounts of computing power, bandwidth, storage and visualization. Pricing CVA at a sell-side firm can involve pricing 100 trades, across 10,000 simulation paths and 100 sample times. This equates to computing 100,000,000 pricing requests for 1 incremental CVA for a counterparty with which you have 100 trades. Over the last few years, large banks and brokerage firms have been quite effective in using distributed computing and grid technology to compute CVA, thus driving down the cost and complexity of doing it. But the growing complexity and new CVA demands described above continue to exert pressure on firms to explore cheaper, faster and more effective infrastructure solutions to perform CVA. The new developments being made in Cloud technology are a significant opportunity for financial services firms to advance risk management further and be able to perform tasks like CVA much better. The next section discusses current and future opportunities for Cloud technology in capital markets including its potential for risk analytics including CVA.

Employing Cloud Technology For Risk Analytics and CVA

CEB TowerGroup estimates that large capital markets firms could realize 5-7% in overall IT cost savings by 2015 using Cloud technology (see exhibit 4). Savings would be driven from shifting applications to a SaaS model, economizing on IT staff and maintenance fees, and consolidating networking, storage and computing expenses. Some of the biggest and best known capital markets firms including Fidelity Investments, State Street, Morgan Stanley and Bank of America have begun using Cloud on the IaaS side, and are increasingly deploying business applications via SaaS. Exhibit 4

Estimated Percentage Savings For Large Securities Firms From Cloud Implementations by 2015

Source: CEB TowerGroup

But Cloud adoption will vary widely across the trade lifecycle (see exhibit 6). Portfolio Modeling, portfolio and risk analytics, and other pre-trade functions will migrate to the cloud the fastest, with firms already

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bursting activities like risk calculations to the cloud. Following that will be post-trade processes like portfolio accounting and securities reconciliation. Trade-related services will migrate to the cloud last due to significant concern around security and performance. Of all the use cases for Cloud technology, few are as powerful as employing it for risk analytics. Many technology firms allow clients to ‘burst pricing calculations to the cloud’ thus providing access to vast amounts of computing power without having to maintain huge data centers or expensive on-premise infrastructure. This flexibility allows traders and risk managers to rapidly deploy new scenarios based on business priorities, thereby delivering much needed business and IT agility. Technology firms like Microsoft provide comprehensive solutions for complex computational needs right from the data management layer, to garner information across the enterprise, to analytics for business insight that is pervasive and allows for a single version of the truth, compute in the cloud, and visualization of risk anywhere, anytime and across any channel. Exhibit 6

Business Value and Likelihood of Cloud Adoption of Major Trade Activities, 2012-2015

Source: CEB TowerGroup

As progressive companies look to do complex Monte Carlo simulations and leverage them to support new functions like CVA trading, they can leverage near real-time computing power that the Cloud provides. This ‘capacity on demand’ has the potential to transform risk analytics (including CVA) allowing firms to perform compute intensive tasks like simulation, risk computation, data visualization and pricing. Exhibit 7 illustrates various options available from Numerix, a leading pricing and risk vendor for conducting analytics in the Cloud. This is just one example of an ecosystem of vendors that are offering Cloud-based risk analytics covering infrastructure, analytics and data management.

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Exhibit 7

Common Use Cases of CVA in the Cloud

Source: Numerix

The ‘Democratization of Risk Analytics Technology’ For a long time now, a relatively small number of financial firms and corporates could afford complex systems, data, highly qualified staff and expensive infrastructure (computing power, storage, bandwidth, visualization) required to do effective risk analytics. Making Cloud technology available to the mass market for risk analytics (and CVA) can broaden the market for such solutions and expand usage among firms that until now were priced out of the market due to huge upfront IT investment. Smaller, less capitalized firms remained at a disadvantage being unable to afford all this. With commodity hardware and new approaches like Cloud bursting, there is a real opportunity to bring complex risk analytics technology to the middle market, if not the mass market. Already, smaller brokerage firms, hedge funds and commercial banks are beginning to sniff around Cloud technology and experiment with it. By 2018, we could see over 35-40% of capital markets firms use risk analytics technology that is currently deployed by only sophisticated firms. This could herald a golden age for risk analytics and a true ‘democratization of risk analytics technology’.

Looking Ahead: The Future of CVA Driven by regulatory requirements, accounting needs and the need to manage risk, financial services firms will continue to bolster their risk analytics capability over the next few years, including CVA. Further amendments to Basel III, OTC Derivatives reform and CRD IV, will impact future CVA requirements, as well as impact the nature and type of CVA technology that is available.

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Regional interpretation of CVA rules and national exclusions for financial entities will prove to be a headache for firms that operate across geographies and wonder what their true obligations are. The recent exception granted to European banks from taking a CVA capital charge for trades conducted with European debt management offices and central banks sets it apart from other regions (Australia, China, Japan, Singapore) where current rules incorporate CVA charges. US firms have no such exemption on CVA charges under Basel III proposals right now. Such exemptions dilute the tenets of Basel III which aims to create a level playing field for financial companies worldwide. Secondly, regional variations in rules would impact the competitive positioning of financial firms as they would be required to hold different amounts of capital for similar business activity. So, as with all international regulations subject to the vagaries of politics and regional interpretation, the future of CVA also hangs in the balance. How rapidly OTC Derivatives trades migrate to a central clearing model will also influence the CVA market. With more trades done via CCPs, it may seem that managing counterparty exposure (and CVA) become moot, but that won’t be the case. First, centrally cleared will progress slowly and it will take another 3-5 years for core products like CDS and interest rate swaps to fully migrate to a CCP. Secondly, some products will always remain in the bilateral OTC market making counterparty risk a perennial issue.

Conclusion Managing counterparty exposure is a capital markets imperative driven by regulatory requirements (Basel III, Dodd Frank Act, EMIR), accounting rules and the overall need to better manage risk. Within the counterparty risk management realm, conducting CVA has emerged as a key requirement and firms are climbing up the CVA maturity curve from ‘reporting’ to ‘managing’ to ‘profiting’ from CVA desks. Another trend is a growing interest in CVA from a broader range of capital markets firms. Rather than just being a concern for large sell-side Derivatives desks, commercial banks and corporates, CVA is gaining interest among smaller capital markets firms, and new users like hedge funds and buy-side firms that were historically not involved with CVA. Computing and managing CVA remains one of the most demanding tasks to perform, requiring enormous amounts of data, analytics, software and computing power. In addition, CVA desks must navigate political issues related to CVA charges with other firm-wide trading desks. Our research indicates that many capital markets firms continue to manage CVA using ad hoc in-house technology, or third party legacy systems that were built 8-10 years ago to do other things. That is a mistake. Firms must adopt a long-term strategic posture towards risk analytics, and invest in vendor applications that are built from the ground-up to handle risk processes like CVA. Furthermore, recent advances made in commoditized hardware and Cloud technology offer capital markets firms the unique opportunity to reduce costs, scale risk functions, and conduct complex calculations that were until now only something that large firms could do. Over the next 2-4 years, such approaches could well broaden the risk analytics market and herald a golden age for risk management technology.

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Numerix commissioned CEB TowerGroup to conduct independent research and analysis of business trends

impacting the risk analytics market. The content of this report is the product of CEB TowerGroup and is

based on independent, unbiased research not tied to any vendor product or solution. Although every effort

has been taken to verify the accuracy of this information, neither CEB TowerGroup nor the sponsor of this

report can accept any responsibility or liability for reliance by any person on this research or any of the information, opinions, or conclusions set out in the report.

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Spotlight on CVA: Trends, Perspectives and IT Implications