WHITE

PAPER
HoW THE cREdIT cRIsIs HAs cHAngEd counTERPARTy RIsK mAnAgEmEnT

Authored by David Kelly (Quantifi)

ey changes to internal counterparty risk management processes K ow increased clearing due to regulatory mandates H affects workflows Key data and technology challenges
www.quantifisolutions.com

About the Author David Kelly

david Kelly, director of credit Products, Quantifi, brings almost 20 years of experience as a trader, quant, and technologist to Quantifi. He has previously held senior positions at some of the largest financial institutions including citigroup, JPmorgan chase, AIg and csFB. At citigroup, he was the senior credit trader on the global Portfolio optimisation desk, responsible for actively managing the credit risk in derivatives positions. Prior to this, he ran the JPmorgan chase global Analytics group, where he was responsible for front-office pricing models and risk management tools for the global derivatives trading desks including the firms first cVA system. An enrolled member of the society of Actuaries, mr.Kelly holds a B.A. in economics and mathematics from colgate university and has completed graduate work in mathematics at columbia university and carnegie mellon.

IntroDuctIon
The credit crisis and regulatory responses have forced banks to substantially update their counterparty risk management processes.
new regulations in the form of Basel III, the dodd-Frank Act in the u.s. and European market Infrastructure Regulation (EmIR) have dramatically increased capital requirements for counterparty credit risk. In addition to implementing new regulatory requirements, banks are making significant changes to internal counterparty risk management practices. There are three main themes inherent in these changes. First, better firm-wide consolidated risk reporting has become a top priority. second, centralized counterparty risk management groups (cVA desks) are being created to more actively monitor and hedge credit risk. Third, banks are making significant investments in technology to better support the firm-wide risk reporting and cVA desk initiatives. 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.

cVA desks have been developed in response to crisis-driven regulations for improved counterparty risk management. How do these centralized groups differ from traditional approaches to manage counterparty risk, and what types of data and analytical challenges do they face?

before cVA DesKs

cVA desks or specialized risk control groups tasked with more actively managing counterparty risk are becoming more prevalent, since banks that had them generally fared better during the crisis.
To establish a basis for comparison, it is important to review counterparty credit risk pricing and post-trade risk management before the advent of cVA desks. The case where a corporate end-user hedges a business risk through a derivative transaction provides a useful example. The corporate treasurer may want to hedge receivables in a foreign currency or lock in the forward price of a commodity input. Another common transaction is an interest rate swap used to convert fixed rate bonds issued by the corporation into floaters to mitigate interest charges are based on an internal qualitative and quantitative assessment of the credit quality of the counterparty by the banks credit officers. The credit portion of the charge is for the expected loss, i.e., the cost of doing business with risky counterparties. It is analogous to cVA, except that the cVA is based on market implied inputs, including credit spreads, instead of historical loss norms and qualitative analysis. The capital portion is for the potential unexpected loss. This is also referred to as economic capital, which traditionally has been based on historical experience but is increasingly being calculated with market implied inputs. These charges go into a reserve fund used to reimburse trading desks for counterparty credit losses and generally ensure the solvency of the bank. The trader on the desk works with the risk control group, which may deny the transaction 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 treasurer explains the hedging objective to the banks derivatives salesperson, who structures an appropriate transaction. The salesperson requests a price for the transaction from the relevant trading desk, which provides a competitive market price with credit and capital add-ons to cover the potential loss if the counterparty were to default prior to maturity of the contract. The credit and capital counterparty is hit. otherwise, it provides the credit and capital charges directly or the tools to allow the trader to calculate them. The risk control group also provides exposure reports and required capital metrics to the banks regulator, which approves the capital calculation methodology, audits its risk management processes and monitors its ongoing exposure and capital reserves according to the Basel guidelines.

While counterparty risk is managed through reserves in this example, the market risk of the transaction is fully hedged by the desk on exchanges or with other dealers. If the transaction is uncollateralized, the banks treasury provides funding for what is effectively a loan to the customer in the form of a derivative line of credit. some portion of the exposure may also be collateralized, in which case there are additional operational workflows around collateral management.

To establish a basis for comparison, it is important to review counterparty credit risk pricing and post-trade risk management before the advent of cVA desks.

counterpArty rIsK WorKfloW before cVA DesKs

Corporate Treasury Derivatives Transaction Bank Derivative Sales Derivatives Pricing Bank Treasury (funding) Funding Derivatives Trading Desk Credit & Capital Reserves Collateral Management Collateral Risk Risk Control Regulatory Capital & Reporting Bank Regulator Market Risk Exchanges & Dealers

cVA DesKs
one of the drivers for cVA desks was the need to reduce credit risk, i.e., free capacity and release reserves, so banks could do more business.
In the late 1990s and early 2000s, in the wake of the Asian financial crisis, banks found themselves near capacity and were looking for ways to reduce counterparty risk. some banks attempted to securitize and re-distribute it, as in JPmorgans Bistro transaction. Another approach was to hedge counterparty risk using the relatively new cds market. The recent international (2005) and u.s. (2007) accounting rules mandating the inclusion of cVA in the mark-to-market valuations of derivatives positions provided additional impetus for more precisely quantifying counterparty risk. some banks attempted to actively manage counterparty risk like market risk, hedging all the underlying risk factors of the cVA. given the complexity of cVA pricing and hedging, these responsibilities have increasingly been consolidated within specialized cVA desks. now, with the increased capital charges for counterparty default risk under Basel III and the new cVA VaR charges, there is even more incentive to implement cVA desks. With a cVA desk, most of the trading workflow is the same except the cVA desk is inserted between the derivatives trading desks and the risk control group. Instead of going to the risk control group for the credit and capital charges, the trader requests a marginal cVA price from the cVA desk, which basically amounts to the cVA desk selling credit protection on that counterparty to the derivatives desk. This is an internal transaction between the two desks, which can be in the form of a contingent credit default swap (ccds). The cVA charge is passed on to the external corporate customer by adding a spread to the receive leg of the trade. unless the cVA is fully hedged, which is unlikely, the spread charged to the customer should also include some portion of economic capital to account for cVA VaR and potential unexpected loss from default. since credit risk spans virtually all asset classes, the cVA desk may deal with multiple internal trading desks. The risk control group treats the cVA desk like other trading desks, imposing trading limits and monitoring market risks using traditional sensitivity metrics and VaR. The cVA desk executes credit and market risk hedges on exchanges or with other dealers and relies on the banks internal treasury to fund positions. To the extent the cVA desk attempts to fully replicate (hedge) cVA, while the derivatives desks also hedge the underlying market risks, there may be some inefficiencies due to overlapping hedges. The key innovation introduced by cVA desks is quantifying and managing counterparty credit risk like other market risks, instead of relying solely on reserves. The main challenge is that not all cVA risk can be hedged due to insufficient cds liquidity and unhedgeable correlation and basis risks. Therefore, some reserve-based risk management is unavoidable. Based on trends among the top-tier banks, the optimal solution involves hedging as much of the risk as possible, considering the cost of rebalancing hedges in a highly competitive cVA pricing context, and then relying on experienced traders well-versed in structured credit problems to manage the residual exposures.

With the increased capital charges for counterparty default 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 Marginal CVA Price Funding CVA Desk Exposure Limits Collateral Management Collateral Risk Risk Control Regulatory Capital & Reporting Bank Regulator Credit Risk Market Risk Exchanges & Dealers

cleArIng
The predominant issues with cVA desks are that they insert another operational layer into the workflow and add substantial analytical complexity.
cVA models have to incorporate all the market risk factors of the underlying derivative plus the counterparty credit risk. Even the cVA on a plain vanilla FX forward is complex because the counterparty effectively holds an American-style option to default. In addition to the option risk profile, the cVA trader must also consider the correlation between the counterpartys default probability and the underlying market risk factors, i.e., wrong-way risk. margining formulas are much simpler than cVA and economic capital models, and new regulations are either mandating or heavily incentivizing banks to clear or fully collateralize derivative transactions. In cleared transactions, the clearinghouse effectively replaces the cVA desk in the workflow. Transactions are assigned or novated to the clearinghouse, which becomes the counterparty to both sides of the trade. counterparty risk is virtually eliminated because the exposure is fully collateralized and ultimately backed by the clearinghouse and its members. There is a remote risk that the clearinghouse fails but the risk control group can focus on relatively simpler issues like collateral management, liquidity, and residual market risks. since cleared transactions are fully margined, the cVA charge is replaced by the collateral funding cost, which is typically based on an overnight rate. not all trades can or will be cleared. clearinghouses will only be able to handle standardized contracts and the dodd-Frank and EmIR regulations specifically exempt corporate end-user hedge transactions from mandatory clearing, so that banks can continue to provide credit lines and risk transfer services through derivatives. It is estimated that at least a quarter of derivatives transactions will remain oTc, which means banks will need to maintain both cVA and clearing workflows.

Transactions are assigned or novated to the clearinghouse, which becomes the counterparty to both sides of the trade.

counterparty risk is virtually eliminated because the 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 Collateral Funding Cost Collateral Management Funding Risk Control Regulatory Capital & Reporting Bank Regulator Credit Risk Clearinghouses Market Risk Exchanges & Dealers

DAtA AnD technology chAllenges

Reliable data feeds that facilitate regular updates and data integrity checks are absolutely fundamental to effective counterparty risk management.
Banks typically maintain separate systems for their main trading desks, roughly aligned by the major asset classes interest rates and foreign exchange, credit, commodities and equities. since counterparty risk spans all asset classes, the counterparty risk system must extract transactions, market data and reference data from all the various trading systems. In addition, supplemental reference data on legal entities crisis, such as wrong-way risk. Regulators are continuously raising the bar in terms of modeling every risk factor, such as potential shifts in basis spreads, volatilities and correlations. new regulatory requirements for back-testing and stress testing are designed to ensure the validity of the model. outputs of the simulation engine include current, expected and potential future exposures, cVA and economic capital by counterparty. The system should also capture counterparty exposure limits and highlight breaches. given the complexity of the inputs and outputs, a robust reporting system is critical. The system should allow aggregation of exposure metrics along a

The most sophisticated global banks have targeted the 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 other databases. These systems typically use different data formats, symbologies and naming conventions, as well as proprietary interfaces, adding significant complexity. The next set of challenges involves balancing performance and scalability with analytical robustness. The simulation engine may have to value on the order of one million transactions over a hundred future dates and several thousand market scenarios. depending on the size of the portfolio and number of risk factors, some shortcuts on the modeling side may be necessary. However, there are critical analytical aspects that cannot be assumed away given their role in the variety of dimensions, including industry and legal jurisdiction. The system should also allow drilling down into results by counterparty netting set and individual transactions. By extension, users should have an efficient means to diagnose unexpected results. There may also be a separate system for marginal pricing of new trades and active management of cVA. The marginal pricing tools need to access results of the portfolio simulation, since the price of each new trade is a function of the aggregate exposure with that counterparty. Because of this, calculating marginal cVA in a reasonable time frame can be a significant challenge. The cVA risk management system provides cVA

sensitivities for hedging purposes. Hedges booked by the cVA desk should flow through the simulation engine so that they are reflected in the exposure and capital metrics. Whereas the cVA desk may hedge credit and market risks, only approved credit hedges, including cds, ccds and to some extent credit indices, may be included for regulatory capital calculations. cleared transactions must be fed to the clearinghouses systems and trade repositories. since clearing involves daily (or more frequent) margining, the banks collateral management system should be integrated with the clearinghouse. It should also be integrated with the counterparty risk system. Ideally,

the simulation engine would upload current collateral positions and revalue them for each market scenario to determine net exposure. The simulation engine should also incorporate the margin period of risk, i.e., the risk of losses from non-delivery of collateral. Even with the crisis-induced wave of improvements, the picture remains very complex. The most sophisticated global banks have targeted the cVA and clearing workflows and supporting technology infrastructure described in this paper. It is expected that regional banks will follow suit over the next few years in order to optimize capital and manage risk more effectively, as well as comply with new regulations.

counterpArty rIsK DAtA floWs & technology InfrAstructure

IR/FX Credit Commodities Trading System(s) Equities

Counterparties Legal Limits

Transaction Reference Data

Market Data Clearing Systems & Trade Repos

CVA Risk Management System

Counterparty Exposure Simulation Engine

Collateral Management System

Marginal CVA Pricing Tool

Reporting

ABouT QuAnTIFI
Quantifi is a leading provider of analytics, trading and risk management software for the global oTc markets. our suite of integrated pre and post-trade solutions allow market participants to better value, trade and risk manage their exposures and respond more effectively to changing market conditions. Founded in 2002, Quantifi has over 120 top-tier clients including five of the six largest global banks, 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 is consistently first-to-market with intuitive, award-winning solutions. For further information, please visit www.quantifisolutions.com

conTAcT QuAnTIFI
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