Gerard Frewen, XVA Product Manager at Bloomberg, was interviewed by Alison Fletcher, a corporate treasury market specialist at Bloomberg LP, on increased interest in different valuation adjustments (XVA) within the derivatives market, and the value of measuring such adjustments on a portfolio basis, especially as hedging activity increases and reporting obligations change.
Q: We get a lot of questions around ‘what are XVA, CVA and DVA?’ Can you explain the differences?
A: The term XVA is really more of an umbrella term for a set of adjustments that are now commonly made to the valuations of bilateral, over-the-counter (OTC) derivatives to reflect costs that aren’t typically included in mid-market valuations. The number of valuation adjustments has expanded, and there’s probably now about five or six that are commonly referred to.
Credit valuation adjustments (CVA) and debit valuation adjustments (DVA) were the original valuation adjustments, and they’re arguably still the most commonly used. CVA was originally introduced to quantify the costs of counterparty risk in OTC derivatives. A way to think about it is the CVA on a trade or a portfolio of trades is the expected loss due to credit risk that you might have. The largest banks began reflecting this within the pricing they showed to the end user probably around 20 years ago. Its inclusion started to be mandated in the accounting standards in the mid-2000s, under FAS 157, and since the financial crisis has been commonly used across the industry. The CVA and DVA, are kind of mirror images of each other.
The DVA represents an increase in the fair value of your derivatives due to the possibility of your own non-performance. It arose from the same accounting standards that originally required CVA, when the requirements for ‘fair value,’ included stating that you need to capture not just your counterparties non-performance, but your own non-performance as well. It’s a much more controversial valuation adjustment than CVA. You report gains on your income statement when your own credit quality decreases. For that reason, while it’s still part of the accounting standards, different banks will manage and price it in different ways.
Q: What has prompted the increased quantity of questions on CVA we are getting from Treasury practitioners of late?
A: It’s probably a function of the increase in derivatives activity in the market in general, which again, really stems from the growth in corporate issuance. We’ve seen the inflationary pressures in the market over the last couple of years, and central banks have increased interest rates to try and mitigate that. At the same time, many corporations now have to refinance maturing debt. In anticipation of those rate increases, however, what we’ve seen is a lot of corporates pre-hedging, using the OTC derivatives market to essentially lock in lower rates of funding in anticipation that rates will rise throughout this year.
We saw quite a lot of that at the end of the fourth quarter in 2022, when rates temporarily took a smaller dip. This year, corporate issuance increased by just over 30% year-over-year from the first quarter last year. We basically associate the additional debt issue as the increase in derivative activity around hedging with all the variability in the markets. CVA is directly impacted by that variability and volatility and as treasuries enter these hedging programs, they become more aware of this.
Q: Why is it important to look at CVA on a portfolio level?
A: OTC derivatives are traded under the ISDA Master Agreement, which is the standard and contractual agreement that participants enter into. What the Master Agreement provides for is the important concept of netting, whereby all obligations that are done under that agreement can be offset against each other in bankruptcy. When you look at placing a new trade, what you want to take into account is really the incremental impact that the trade will have on your overall exposures to a counterparty. That then feeds through to what the incremental impact will be on your CVA. For example, if you have a portfolio of swaps, where you’ve been paying fixed and you now need to do a trade where you receive fixed for some reason, that will offset the risk that you have with your counterparty. You will end up reducing the counterparty CVA.
Capturing the portfolio effects is really important because it’s the only way to really quantify what the true incremental impact on your exposure is, and hence on your valuation adjustments from entering into that transaction.
Q: As per accounting standards one might have to quantity CVA for reporting needs – How do Bloomberg’s Risk Products (MARS), like Hedge Accounting (HEFF), help manage the valuation adjustments?
A: Our MARS suite of products is intended to address the full set of use cases from valuing derivatives to calculating the XVA adjustments. For hedge accounting, when you’re looking at the actual performance of your hedge and the actual impact, you do need to take into account the actual CVA in that pricing of your OTC derivative. MARS XVA is fully integrated with our hedge accounting HEFF product, which enables our HEFF clients to also access our CVA analytics and take those into account for their hedge accounting purposes and to quantify their effectiveness.
Q: Traditionally, people have embraced CVA-adjusted mark-to-market on rates derivatives. But are you seeing an uptick of interest in other asset classes as well?
A: Yes, absolutely. Historically, just given the fact that interest rate hedging and cross currency swaps tend to be the longer-dated transactions in the bilateral OTC derivative space, they have tended to be the bigger drivers of CVA. People typically have the most CVA exposure there as — the longer date of the transaction, the more volatility there is, and hence the greatest potential exposure and the expected losses.
What we have seen over the last couple of years, particularly with the uptick in hedging and the changes in the commodities market, is a significant increase in commodities clients looking for help to quantify their CVA, both on the producer and on the end user side. New participants are entering the commodities market, with a number of smaller firms across oil, gas and metals. When those firms trade with banks, they have their own credit provisions, and as a result, we’ve seen a lot of inquiries about it this year. To meet that need, we’ve added coverage of that within MARS products as well.
Q: How has CVA market conventions changed from LIBOR to SOFR?
A: That’s been a key topic over the last couple of years, as we’ve seen our clients prepare for the LIBOR transition. They’ve moved away from a world where you have derivatives on your books, and know upfront what the rate is going to be for the next period. The other major change is moving to a world where you’re waiting to calculate compounded rates in arrears, and then determine your cash flows based on that. For corporate clients, it has been a major change getting used to that world.
Another big consideration is the Secured Overnight Financial Rate (SOFR) coming into the market as well as a hedge for loans. From a valuation perspective, we’ve basically moved away from a rather simple structure to one that’s a little bit more complex for our clients. It’s something we’ve looked to enhance on the CVA side as well, too, in that we’ve enhanced our models, we’ve implemented some improvements around handling the nuances of the risk-free rate markets and with payment delays.