26 April 2013

Bundesbank: Restructuring counterparty credit risk

Whenever a defaultable entity enters into a financial transaction, it sustains a cost of carry to compensate counterparties for its potential inability to meet future contractual obligations. The compensation mechanism for counterparty credit risk is captured by a protection contract contingent to the default arrival time and to the exposure at default (EAD). In the particular case of debt transactions, the cost of carry of the contingent default protection liability is the cost of funds above the riskless rate. In the case of derivative contracts, the cost of carry of default protection is either captured by a credit valuation adjustment (CVA), or by the cost of posting collateral, or a combination thereof.

In the past two decades, financial markets witnessed the implementation of different standards for valuation of counterparty credit risk. The evolution of these standards was driven by a desire to achieve a consistent valuation, an objective still not fully achieved in Basel III regulatory documents and ISDA Master Agreements. The current standards for bilateral credit valuation adjustments are also plagued by various paradoxes related to own default risk (debit valuation adjustments, DVA) accounting which encourages anti-economical behaviour by incentivising firms with poor credit policies and penalising firms with good credit policies. Moreover, these paradoxes place an insurmountable limitation to the ability of replicating dynamically the price process of derivative transactions, a serious problem that hampers the role of banks as financial intermediaries.

Paper’sfirst proposal regarding a logically and financially consistent valuation framework for CVA and DVA involves an inclusion of a first-to-default clause in default protection contracts. This modification however represents a substantial deviation from the unilateral CVA (UCVA) specification in Basel III. To remedy in part, authors introduce the new notion of a portable CVA (PCVA) which is logically and financially consistent and also very close to the UCVA.

Next they deviate from bilateral contracts and consider three counterparty credit risk mitigation structures based on margin lending and full collateralisation. Paper concludes that the quadri-partite structure is the most promising one, whereby two margin lenders provide hypothecs to ensure full collateralisation at all times to cover the open mark-to-market value of derivative transactions. These structures do not require a bank to carry out CVA trading, and hence would eliminate a source of significant market risk. Moreover, conditional counterparty spread volatility risk is transferred to the counterparty. Pure default risk is retained by the margin lenders that can securitise it in a straightforward manner without being hampered by CVA volatility risk. Authors continue by introducing a penta-partite structure which is a variation of the quadri-partite structure above with the inclusion of a central counterparty. In the penta-partite case, it is concluded that, if a replication strategy between non-defaultable entities exists, then this strategy can be implemented also by a defaultable structurer until its default time and the cost of replication is the risk-free fair value, independently of the credit quality of the structurer.

The authors finish their paper with a short illumination of the case where finite liquidity is included.

Full discussion Paper

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