Capital Markets Advisors

Turning Change Into Opportunity


IFR 2035 31 May to 6 June 2014 | By Christopher Whittall

Costs associated with running derivatives businesses continue to mount, as the industry gets to grips with the latest addition to the alphabet soup of charges associated with swaps portfolios – Additional Valuation Adjustments, or AVA.

Tabled by the European Banking Authority in a consultation paper in December last year, AVA – or prudential valuation as it is also known – forces firms to set aside reserves to take account of uncertainty in derivatives valuations recorded in their financial statements.

The measure stands apart from other similar-sounding swaps valuation adjustments that banks are wrestling with, such as CVA, DVA and FVA, which all pass through the banks’ profit and loss statements.

Instead, AVA – which one senior banker estimated would run to hundreds of millions of euros for major dealers – is subtracted directly from a firm’s capital position. With derivatives businesses already feeling the pinch from beefed up capital requirements under Basel III, dealers say AVA is yet another cost that will have to filter through to end-users.

“AVA clearly complicates the derivatives business and it may overlap with other charges or reserves that we are already counting in P&L. All these costs have to be passed on, which means derivatives products are becoming more and more expensive for end-users,” said Elie El Hayek, global head of rates at HSBC.

“Just look at the difference between a Forward Rate Agreement and futures,” El Hayek said. “The FRA is much more expensive, which is a bit of a nonsense when it’s exactly the same risk. Likewise in the uncleared world, it’s much more expensive for a corporate to do a vanilla swap than issue a bond, even though it is the same exposure for the bank.”

Prudential valuation of derivatives is not a new concept, having always existed under the Basel accords. The measure is particularly relevant for illiquid derivatives positions, which are tricky to value due to a lack of observable market prices.

For example, there may be a number of inputs to calculate the value of a derivatives liability, which puts it at somewhere between, say, US$80 and US$90. As a result, an accountant may deem the fair value of that position to be US$85. However, regulators want the bank to hold reserves to cover the most conservative valuation of the swap – US$90 – resulting in the creation of an AVA provision of US$5.

“It’s always been the case under Basel that the regulatory balance sheet should be drawn up on a prudent basis. Then, a few years ago, people realised accounting estimates of fair value are not necessarily prudent values,” said Colin Martin, a partner at KPMG. “AVA is not about changes in fair value or market risk – it’s a regulatory measure to cover valuation uncertainty.”

When vanilla becomes complex

AVA is the latest in a long line of charges that derivatives businesses must absorb and, ultimately, pass on. Some of these costs have long been priced in by traders on an informal basis, but have only recently appeared as line items in banks’ accounts. Some dealers started pricing in CVA – the counterparty credit risk charge – back in the early 1990s.

Taking into account the bank’s own credit risk – or DVA – was a more controversial practice, but one that is now also formalised by accounting standards. Factoring in the funding costs of the swaps – or FVA – currently divides the industry, but is expected to eventually become common practice. JP Morgan made waves this year when it joined the pro-FVA camp, while incurring a US$1.5bn hit.

“In the old days, there was complexity on products with leverage and pay-off. Now, the derivatives are simple – the complexity is in the accounting. The world has been turned completely upside down,” said the head of markets at a major dealer.

These swaps charges once amounted to a couple of basis points, whereas now they can be in the region of 20bp–40bp depending on the trade, dealers say. This can make it prohibitively expensive to assign or restructure old swaps, a particular problem for sovereigns with large legacy exposures from the pre-crisis days.

Banks have been working hard behind the scenes to broker a compromise with these high-profile clients to unwind costly positions. Morgan Stanley famously reduced its exposure to the Italian treasury by US$3.4bn in late 2011 by exercising the break clause on an interest rate swap.

Future issues

Rising costs also have implications for future business. Capital-intensive, long-dated transactions are becoming harder to justify as the charges rack up. Participants identify cross-currency swaps – which allow issuers to tap into demand for their paper in different countries – and inflation-linked derivatives as two instruments in particular that lose their appeal under the new regulatory regime.

“You need a much more significant difference in the spread to do a cross-currency issuance arbitrage than you did in the past. Cross-currency business will automatically slow as a result,” said El Hayek.

The head of markets goes even further, warning that corporate and sovereign clients will simply shun derivatives instruments altogether rather than stomach the spiralling costs and accounting complexity that accompany the trades. However, others argue that accounting for these costs is simply formalising what banks were doing behind the scenes anyway.

“The perceived increase in accounting complexity is really just the market developing more sophisticated tools to reflect the true economics of a derivatives trade,” said KPMG’s Martin. “Derivatives are evolving in line with changes to regulation, netting, tax and other market norms, and this will have a knock-on impact on accounting valuation too.”

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