Blamed for magnifying the effects of the financial crisis, credit derivatives may be given a boost by the post-crisis regulatory changes.

When the financial crisis exposed the flaws in investment banking's risk management in 2007 and 2008, regulators reached a number of important conclusions. The first was the role of credit default swaps (CDS) in magnifying the effects of subprime mortgage defaults. These instruments had been used to create credit exposures, especially through synthetic collateralised debt obligations (CDOs), that far outstripped the cash bond market itself.

The second was the incorrect use of existing tools for measuring market risk, especially in complex products such as CDOs, where pricing was affected by credit correlations. In particular, the Value at Risk (VaR) concept, which calculated the maximum daily loss likely to occur over a set period (usually 10 days) to within a certain probability (usually 95% to 99%), appeared to leave a number of vital blind spots.

“VaR works well in a normal market, especially if buttressed with stress-testing. But what it cannot address is the effect of the jump to illiquidity in periods of market distress. Once market conditions and asset prices move beyond that 99% probability, VaR does not give you any indication of what the tail-risk losses may be,” says Peter Sime, head of risk at industry body the International Swaps and Derivatives Association (ISDA), and a former head of risk for the European operations of US bank Wachovia.

The third lesson was the importance of counterparty credit exposure created by any derivative trades that were not collateralised. In particular, contingent valuation adjustment (CVA) – the changes in the credit quality of derivative counterparties – are marked-to-market for accounting purposes, creating profit and loss volatility for broker-dealers.

Tim Grant is today the head of sales for Benchmark Solutions, which creates market-driven pricing for over-the-counter (OTC) fixed-income products. In 2007, he was working for UBS, where he was drafted in by the chief risk officer to manage the fallout from the bank’s exotic credit portfolios. “The losses that were making a difference even on a daily basis were mostly CVA related rather than market related,” says Mr Grant. While banks already held reserves for outright default by derivative counterparties, they were not protected against mark-to-market deterioration of counterparty creditworthiness. Yet this accounted for about two-thirds of losses on derivative counterparty exposure, according to the Bank for International Settlements.

Correlation penalised

In the immediate aftermath of the crisis, the regulators of the Basel Committee hastily assembled an interim arrangement during 2009, dubbed Basel 2.5, which included a number of additions to trading book capital charges on top of VaR. For credit correlation books, banks must employ a comprehensive risk measure that covers ratings migration, default and price risk at the 99.9% confidence level over a one-year horizon.

“The immediate consequence was to try to simplify the exotic correlation books, mainly synthetic CDOs, because there is a cost for complexity. On top of having a comprehensive risk measure on these, there is also a floor on the amount of capital that must be held based on a standard charge that does not give much credit to the way the book is hedged. It is really a tax on the size of the correlation book,” says Benjamin Jacquard, global head of credit trading at French banking group BNP Paribas.

The immediate consequence was to try to simplify the exotic correlation books, mainly synthetic CDOs, because there is a cost for complexity

Benjamin Jacquard

Terri Duhon, managing partner of consultancy B&B Structured Finance and a former credit derivatives trader and structurer for banking corporations JPMorgan and ABN Amro, says that the heavier regulation of banks means that hedge funds have become the dominant players in trading credit correlation. That creates a more difficult environment for banks to operate market-making activities profitably.

It also affects the liquidity in the CDS market, because new issuance and portfolio rebalancing of synthetic CDOs accounted for up to 50% of total CDS trading before the crisis. Liquidity is now more focused on the major CDS indices such as the iTraxx series in Europe and CDX series in North America, as well as the single names that are included in those indices. In addition, most trading focuses on benchmark five-year maturities.

“The degree of liquidity lost once names go off-index was less between 2004 and 2007 because there were many synthetic structured credit deals that required diversity for their ratings, so they were using off-the-run maturities and off-index names,” says Brett Tejpaul, head of global credit sales at UK bank Barclays.

Fundamental rethink

Overall, bankers estimate that the new regulations increased market risk-weights by about three to five times. Regulators acknowledge that Basel 2.5 is an imperfect creation, which forces banks to pile several different risk measures on top of each other. This may not match the way in which banks want to conduct their own risk management or measurement of economic (as opposed to regulatory) capital.

“At UBS we used to ask ourselves, once we are out of the crisis phase, how would we reconfigure our risk management operations? One major answer was the better aggregation of risk data across trading desks in real-time. Similar types of risk should be measured using a unified approach across the bank, instead of siloing them in each trading desk,” says Mr Grant.

Consequently, the Basel Committee launched a fundamental review of the trading book in May 2012, for the incorporation of Basel III that is due to come into force from 2013 with a transition period until 2019.

“This review is an opportunity to unify regulation and replace a patchwork treatment of trading book risks with a more holistic perspective that better captures and capitalises the risks,” says Mark White, senior vice-president for capital management and optimisation at the Bank of Montreal. As Canada’s assistant superintendent of financial institutions until 2011, he chaired the Basel Committee’s risk management and modelling group.

Marginalising operations

There is a feeling among bankers that some on the Basel Committee see the review simply as an opportunity to marginalise trading operations by making them more difficult and capital intensive. In particular, the possible use of a standardised floor for capital requirements on trading books would prevent banks receiving capital relief for taking a more sophisticated approach to trading risk management.

Mr White notes there is a danger that the standardised floor could create perverse incentives for cost-conscious banks to be more simplistic in their risk management strategy, due to the lack of immediate regulatory reward for better risk measurement. His preference is to improve disclosure, creating market discipline by allowing regulators, investors and other banks a clearer view of each bank’s trading risk management.

“If the whole market can see that one bank is able to lower the capital requirements on its trading book by 20%, while the market standard is more like 10%, then everyone will have the chance to ask suitable questions about that bank’s internal models and capital adequacy,” says Mr White.

New risk regime drives credit derivatives business

Rethinking the model

One proposal in the Basel review is to replace VaR as the regulatory risk measurement with a system-called expected shortfall, which is perceived as better for incorporating tail risks into the model. There is general consensus that the exact model which regulators eventually adopt is less important than the infrastructure and systems that banks use to implement it. For the credit derivatives industry, an OTC market with low trading volumes on some CDSs and the historic control of market data by a small group of broker-dealers had made it difficult for players in the credit market to calculate and report risk reliably in real-time in the way that cash equity managers have for some time.

Technology providers are now working to change that, and Benchmark Solutions has built a system that assimilates unstructured and reported trade data to create more accurate and broader risk-of-default information. The system already covers about 2000 names, whereas Benchmark’s chief scientist, Dr Peter Cotton, estimates that there are at most 800 single-name CDSs that trade frequently.

“There is a lot of misdirection in indicative OTC prices quoted by broker-dealers compared with where credit actually trades. We have taken a mathematical approach to assessing what data is valuable, what incoming sources are valid, to automate time-consuming processes into a consistent statistical framework in a way that humans cannot,” says Mr Cotton, who previously headed efforts to improve correlation modelling at US financial services firm Morgan Stanley.

A matter for management

Inevitably, the debate about risk management has been coloured by the heavy losses on credit derivatives disclosed at the chief investment office at JPMorgan. Risk managers elsewhere express alarm that traders at the chief investment office were allowed to take positions in illiquid, off-the-run CDS indices and tranche trades that were so large that many other market participants became aware of them. This made them difficult to exit even once managers became aware of the scale of losses.

There is also surprise that the chief investment office team appeared to make little use of JPMorgan’s own market-leading credit trading desk, which has built considerable expertise and infrastructure around managing credit derivative exposures. This runs counter to the general industry trend to ensure that risk management practices are consistently applied and handled by specialists across the bank.

Correlation between asset classes is quite high at the moment, which can trigger bursts of one-way activity from CVA desks if many derivative mark-to-markets move in the same direction

Brett Tejpaul

However, pushing banks toward more unified use of risk tools is only half the battle. Jean-Pierre Lardy was a managing director at JPMorgan working on credit derivatives and later credit portfolio risk management until 2005, and he now advises mostly hedge funds on implementing systematic trading strategy models. He believes size is a profound challenge for rolling out effective risk management models.

“In smaller institutions such as hedge funds, when the driver and the mechanic sit next to each other, they both own the risk model – they keep the model honest, check the inputs are correct, and it keeps them honest. But if the model is imposed across a large bank, or even more so by a regulator or a rating agency across the whole banking sector, users take less care about the model imperfections, and it can generate a false sense of security,” says Mr Lardy.

CVA uncertainty

Perhaps in recognition of the complexity of the task, the Basel Committee decided to postpone a fresh review of the CVA risk charge altogether, even though it logically sits within the review of trading book risks. Under Basel 2.5, regulators instructed banks to model CVA risk using bond or CDS spreads as an analogy, which bankers estimate doubled the capital charge for counterparty exposures.

The transition to dynamic measurement and hedging of CVA is perhaps less of a transformation for investment banks that had already pursued a purer intermediation role and are accustomed to selling down most of their risks into the market. It is a more substantial cultural change for corporate and investment banking models at the universal banks, which are used to retaining a balance sheet relationship with major corporate clients.

Manoj Bhaskar, global head of regulatory and risk analytics at HSBC, points out that banks’ CVA losses on corporate counterparties during the credit crisis were very limited. Instead, most of the CVA losses stemmed from exposure to monoline insurers that were CDS counterparties on structured credit transactions. The crisis destroyed much of the monoline industry, and the survivors are now staying well away from underwriting structured credit in any case.

The ISDA's Mr Sime is also concerned about the standardised approach to CVA measurement outlined by Basel. While this is helpful for smaller banks with less risk management infrastructure, he says that the model as currently proposed is poorly calibrated. “At the moment, the model requires banks to hedge exactly using single-name CDSs, it ignores generalised hedges that use CDS indices, or, for example, hedging sovereign risk with corporate CDSs in the same country. This means a risk manager who carries out portfolio-wide hedging could even end up increasing the capital charge for their bank.” 

The requirement for relatively exact CVA hedging to receive capital relief also raises concerns about whether heavy single-name protection buying will trigger imbalances in the CDS market. Mr Bhaskar estimates that a relatively small number of corporates in Europe have actively traded CDSs.

“If banks are not allowed to use proxy hedging, this has significant implications. There could be a one-way street, with banks becoming reliant on hedge funds to write single-name protection, which would also raise new questions of systemic risk,” he says.

Winning back clients

The fears about the effects of increased CVA hedging are not universal, however. Mr Tejpaul at Barclays says CVA desks are only significant net buyers of protection in the initial set-up stage.

“Once the desk is in motion, there should be a steady turnover of protection buying and selling as counterparty risk on uncollateralised swap transactions rises and falls daily. However, correlation between asset classes is quite high at the moment, which can trigger bursts of one-way activity from CVA desks if many derivative mark-to-markets move in the same direction,” he says.

While bankers fret over the cost of regulatory changes that include not only higher capital requirements on trading books, but also the push to central clearing of credit derivatives, it is important not to lose sight of the clients. Sherif Hamid, head of European credit strategy research at Barclays, suggests that these measures will make the market more reliable from an investor perspective. That could tempt a return by some non-banks who forsook the CDS market after 2008 due to fears over volatility and counterparty risk.

Already, trades in some of the major CDS indices can be executed through electronic platforms, boosting liquidity and transparency. And the wider price differentiation of credit quality – especially for European sovereigns whose spreads were previously grouped very tightly together – has created far more opportunities for long/short credit funds.

“CDS trading volumes are much less correlated to primary market issuance than they used to be. When volatility hits the market, cash bond and primary market volumes fall, but CDS volumes often rise as hedging and relative value trading activities increase, so this can be a counter-cyclical business," says Mr Hamid.

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