CVA is here to stay

Nine months ago we at Hedgebook engaged audit firms, banks and corporates to discuss Credit Value Adjustment (CVA) and Debit Value Adjustment (DVA) as the introduction of IFRS 13 loomed. The overwhelming response was one of ignorance and/or disinterest. Either they didn’t know about it or they didn’t want to know. On my recent business trip to Europe an audit firm in France recounted a story about a get together they had with their clients to explain the requirement for CVA. The whole room burst out laughing. Adjust the financial instrument valuations for my credit worthiness – you must be kidding.

In some ways this wasn’t surprising as IFRS 13 really only began to impact corporates for their 31 December 2013 annual results, even though their half year results should have included the adjustment. Now six months down the track and the requirement to adjust for credit worthiness can’t be ignored.

Whether we like it or not the valuation of financial instruments has become more complex as the regulators are now focusing more closely on this area. In fact when we talk about valuations for financial instruments the understanding is that it includes the credit adjustment under the new standard. CVA is part of this change in focus and is here to stay. The question for corporates therefore is how do I calculate these values accurately but in a simple and cost-effective way?

Although this isn’t new for the US it is new for the rest of the world and it appears that Australia and New Zealand are leading the charge. Europe has been pre-occupied with the new regulatory changes, especially the reporting requirements under EMIR and so it is only now that it has come on their radar.

Of course CVA and DVA are not new. The banks have been adjusting for credit for a number of years but in the corporate space it is new and many have tried to over complicate the calculation. Monte-Carlo simulations might be appropriate for companies that have cross currency swaps or more exotic option hedging strategies but the vast majority of corporates globally are using vanilla products – fx forwards, options and interest rate swaps. For these instruments a simple methodology to calculate CVA is not just acceptable but also appropriate.

It appears that common sense is already coming to the fore with the current exposure method gaining common acceptance, where the discount curve is flexed to adjust for the credit worthiness of both parties. Although a more simplified method it is still not straightforward, requiring two valuations and an adjustment of the yield curves for credit margin. Not something the banks will be providing and so therefore there is the requirement to source this from someone who specialises in financial market valuations. It doesn’t need to be expensive though and there are low cost solutions available.

Given the numbers are mostly small there is a natural reluctance to pay very much for what are in some cases reasonably immaterial numbers. However the audit firms are insisting on its inclusion and rightly so – it is a requirement under the accounting standards and the materiality or immateriality needs to be proven. Of course credit conditions are benign at the moment but as we know this can change quickly and it won’t take much to make the credit adjustment more material.

New European Hedgebook distributor

We are pleased to announce the appointment of Konzept1 as our distributor of HedgebookPro in Germany and Austria.

Konzept1 markets third party software and is headed by Jorg Leuker. Jorg has previously been a user of HedgebookPro and was so impressed with the system he wanted his company to be able to distribute the product.

Jorg explained that “with the increasing reporting and compliance requirements HedgebookPro, with its simple and intuitive interface, fulfils a need in the German market”.

We look forward to working with Jorg and Konzept1.

LIBOR rate set: massive fee hikes

The LIBOR rate-setting scandal has resulted in a massive increase in the cost of LIBOR to users and distributors of that rate. Given that $350 trillion of financial products have LIBOR as the underlying reference rate then that equates to a huge number of users. LIBOR is used as the rate-set for a vast array of financial instruments such as FRAs, interest rate swaps, interest rate options, loans and mortgages across a number of currencies (GBP, USD, CHF, EUR, JPY). Owners of such instruments need to know the LIBOR rate-set to determine cashflows.

LIBOR, or London Interbank Offered Rate, is set daily by the world’s largest banking institutions and was supposed to represent the rate at which these banks could borrow for pre-determined time periods. The manipulation of LIBOR first came to light with the onset of the global financial crisis in 2008 as the benign credit environment spectacularly imploded. The high levels of short-term debt held by institutions became incredibly expensive to fund, that’s if it could be funded at all. Banks became fearful of lending to each other as they did not have confidence that they would be repaid. During this period LIBOR was cynically dubbed “the rate at which banks don’t lend to each other”. The chart below shows the fear that gripped the interbank market at the height of the GFC when rates spiked to close to 7.00% for USD LIBOR.

USD LIBORThere were two main incentives for banks to manipulate LIBOR:

  • to give the impression banks’ balance sheets were healthier than they actually were
  • to profit from trading activities

Since the scandal first came to light there have been huge fines handed out to complicit banks, criminal investigations, as well as reforms in the administration of LIBOR. Since the mid-1980s until recently, the administration of LIBOR was carried out by the British Bankers’ Association (BBA). Earlier this year the administration of LIBOR was taken over by NYSE Euronext which is regulated by the UK’s Financial Conduct Authority. NYSE Euronext is now owned by the Intercontinental Exchange (ICE) Group.

As of 1 July 2014 the ICE Benchmark Administration is introducing a new commercial model for users and distributors of LIBOR. The fee depends on:

  • the timeliness of the data (live data is more expensive than delayed data)
  • who is using the data (financial institutions are charged more than non-financial institutions)
  • whether the data is being redistributed (such as via treasury systems).

From a rate-set perspective there has been a move away from LIBOR. In the 1990s there were 16 currencies that used LIBOR which dropped to 10 following the introduction of the Euro. There are now only five currencies. The most recently terminated currencies are the CAD, NZD and AUD with rate-setting now determined by CDOR, BKBM and BBSW respectively. Although these rate-sets are managed by various bodies, and come at a cost, at least the user, or redistributor, can pick and choose which rates/currencies to subscribe to. Unlike ICE which provides all five currencies whether you want them or not. Here’s hoping the additional regulation for these rate-sets eradicates corrupt practices. Unfortunately, as we have seen with the breaking of the forex rate-setting scandal there is plenty of other opportunities for greed and dishonesty.

Understandably increased administration costs, as well as the costs of (as it turns out much needed) regulation/policing, need to be recouped, however, the quantum of the fee increase seems excessive. As we have previously commented there is a clear trend for higher data costs and this is one of the challenges we at Hedgebook need to navigate to provide a simple and intuitive, but also low cost, treasury management solution.



CVA module: simple and inexpensive

We have been busy developing a Credit Value Adjustment (CVA) module over the last couple of months which will be released prior to 30 June 2014. The timing allows users with 30 June balance dates to inexpensively include CVA/DVA as part of the fair value of their financial instruments as prescribed by IFRS 13.

In line with the Hedgebook “demographic” we have deliberately kept the CVA module towards the simpler end of the CVA calculation spectrum. We use the current exposure method which we feel is appropriate for vanilla instruments such as fx forwards, fx options and interest rate swaps for an entity using these instruments for hedging purposes.

The module is broken into the following steps:

  • Creating new credit curves (both for the counterparty to the transaction and the company’s own credit).
  • Managing previously created credit curves
  • Assigning credit curves to instruments
  • Running the CVA/DVA report

Creating credit curves

The user needs to include at least one data point for Hedgebook to create a credit curve. Hedgebook linearly interpolates/extrapolates as appropriate. The more data points that can be included the better and sources such as treasury advisors, banks, corporate bonds and bank funding costs are all useful sources for determining credit spreads. The user will need to add at least two curves – one to reflect the counterparty to the transaction and one to represent the company’s own credit standing. Hedgebook adds the credit curve to the risk-free curve so that future cashflows can be discounted to present value and compared against the risk-free valuation.

Once the credit curves have been added they are saved and can be amended/deleted as necessary:

Manage credit curve

The final step before running the report is applying the counterparty credit curves to individual deals as appropriate. All of the curves created by the user are available.

Assign credit curve

Once the user is satisfied the deals have been correctly assigned with a credit curve, the CVA report can be run. The output of the report is split by instrument type and includes the risk-free valuation as well as the fair value and CVA/DVA amount.

CVA report

We have focused on providing a relatively simple solution to a new and complex area of financial reporting. For many companies 30 June will be the first time CVA/DVA has been included in the fair value of financial instruments. If CVA is causing you an expensive headache then get in touch because we can help.