FVA hedge omission from FRTB set to cause headaches

Lack of carve-out for market risk hedges could create hedging issues, experts say

While the incoming Basel market risk rules will ease capital consumption of counterparty credit hedges for uncollateralised derivatives trades, the lack of an equivalent carve-out for funding costs could create hedging challenges for dealers.

Banks’ credit and funding-related derivatives exposures can be inflated by changes in the market price of derivatives positions. This risk is hedged by the derivatives valuation adjustment (XVA) desk, which typically puts on interest rate and foreign exchange hedges as a mitigant. While US and Canadian rules exempt those trades from risk-weighted asset calculations, European rules treat those hedges as naked positions in the book – a source of great frustration to dealers.

The new credit valuation adjustment (CVA) rules that come in as part of the Fundamental Review of the Trading Book (FRTB) – and are tipped to be introduced in Europe in January 2025 – will for the first time provide carve-outs for those market risk hedges of counterparty credit risk exposures. But no such mitigant will be available for equivalent market risk hedges of funding valuation adjustment (FVA) – which captures the funding costs of uncollateralised or imperfectly collateralised derivatives positions.

“If you run full-blown active risk management, then you will enter a situation where you’re hedging something that the regulation does not recognise, and so it might look like you have naked hedges on – which will carry a cost in their own right. That’s a complete nightmare from my point of view,” said Nicki Rasmussen, head of XVA at Danske Bank, speaking on an XVA webinar hosted by Risk.net on November 10.

Speaking on the same webinar, Stuart Nield, global head of product and financial risk analytics at S&P Global Market Intelligence, agreed that the omission of FVA from incoming FRTB-CVA rules could create hedging challenges for market participants preparing to use the new standardised approach to CVA (SA-CVA), one of the two available methodologies under the incoming framework.

“XVA desks that would typically hedge the net of their CVA and FVA will now have to split off the part of their hedge which is going into CVA away from the bit that’s hedging FVA for the purpose of correctly offsetting their CVA risk in their SA-CVA capital framework [which could lead to naked positions on your book]. That’s a change that we’ve been talking to some of our clients about,” he said.

Rasmussen said it also raised more existential questions about FVA itself. While post-crisis there was significant debate about its existence in the quant community, it has been a steadily accepted part of bank accounting since JP Morgan took a $1.5 billion adjustment in 2014. However, while CVA has been recognised as a risk that needs to be capitalised, FVA has never featured in such guidelines.

“Being in a bizarre situation where the regulation doesn’t recognise FVA will create some interesting challenges within an organisation. What’s the right thing to do? Does FVA exist or not?” he said.

Rasmussen believes regulators should instead look at how banks actually prudently hedge these risks in practice, and take a closer look at banks that ignore them.

“I think that would be a better approach. Most banks are quite responsible and care about profit and loss, risk, and results, so if there are some that do a good job, then that should be the starting point for any regulation,” he added.

While FVA’s current omission from capital rules is a concern, this year XVA issues have mostly stemmed from CVA. Indeed, BNP Paribas’s CVA jumped 18% in the second quarter this year to reach its highest level reported since it started disclosing charges in 2014.

Nomura also saw a $17.8 million net CVA and debit valuation loss in the three months to the end of September, its biggest in two years. The figure shows the net difference between DVA – adjustments to derivatives liabilities from changes in the bank’s own counterparty credit risk – and the CVA figure.

The bout of gilt volatility in September after the UK’s ill-dated mini-budget also led to a sharp rise in CVA for dealers with cross-currency swaps with UK corporates.