New developments in XVA: bank strategy in a changing world

Derivatives valuation has grown in complexity since the the financial crisis that began in 2007–08. It now encompasses a broader range of risk factors, including credit, funding, margin and capital – all of which can affect banks’ competitiveness and profitability

The panel

• Allan Cowan, Global head of financial engineering, financial risk analytics, S&P Global Market Intelligence
• Connor Campbell-Coleman, Head of XVA and derivative optimisation, group balance sheet management, Lloyds Bank − Group Corporate Treasury
• Florent Kpodjedo, Director, National Bank of Canada
• Viktor Mofokeng, Head of long-term credit portfolio trading, Absa Group
• Moderator: Philip Harding, Commercial editor, Risk.net 

Ongoing regulatory changes, coupled with market volatility, have resulted in an ever-changing landscape for valuation adjustments – known collectively as XVA – desks to navigate as they tackle the challenges of managing exposures, optimising capital and continuously improving risk and trading decisions. 

At a recent Risk.net webinar, sponsored by S&P Global Market Intelligence, the panel discussed and shared insights on some of the main issues XVA specialists are currently facing. This article explores the main themes emerging from the discussion.  
 

Key challenges

US bank failures and the demise of Credit Suisse were seen as the key developments occupying XVA desks in 2023, having led to higher levels of volatility in credit spreads, with an outcome of increased XVA charges and reduced profitability. 

Reflecting on other issues that have demanded the most attention, Lloyds Bank’s Connor Campbell‑Coleman listed the impact of the war in Ukraine and last year’s liability-driven investment crisis during the Truss government. He added that inflation and central bank actions were some of the most recent preoccupations. 

Allan Cowan, S&P Global Marketing Intelligence

Allan Cowan, global head of financial engineering, financial risk analytics at S&P Global Marketing Intelligence, singled out interest rates: “The move to higher interest rates is the shift that has been persistent and is here to stay,” he said.

Sharing his perspective on the challenges affecting XVA in Africa, Viktor Mofokeng of Absa Group remarked on how the continent has had its own defaults to contend with, as well as the impact of those further afield, adding: “As an XVA trader on the continent, not only do you have to struggle with the big news like US bank failures and what that introduces to the market, but you also have to deal with other complexities.”
 

Volatile conditions

Considering the specific challenges for XVA desks under volatile conditions, Cowan commented: “With more volatile credit spreads or volatile risk factors, there is a need or desire to rehedge often. This can drive up costs if you’re always chasing the perfectly hedged portfolio. 

“A short-term strategy is required to adapt your hedging strategy. It’s critical to balance the hedge, so you need to consider whether the risk factor driving volatility creates systemic risk across your portfolio and you need to adjust, or whether it’s prudent to wait and let it revert to the mean. Having the tools that allow you to stress-test − or undertake a ‘what if’ analysis on what is happening in the market in real time − is key.”

The issue of wrong-way risk was also identified as a particular challenge for XVA desks: “We have to be conscious of structural wrong-way risks within our portfolios,” said Campbell-Coleman. 

He added: “XVA is not just about pricing and risk managing. It also involves interacting with the rest of the business, to try to influence strategy. This requires a lot more contact between areas that traditionally don’t interact much. XVA, repo, treasury and operations should all be co-ordinated. That’s quite a challenge, but it could also add a lot of value.” 
 

Adoption of MVA and use of KVA  

The audience was invited to participate in a poll about the adoption of margin valuation adjustment (MVA) by the XVA desk. Almost half (45%) said it was important to quantify it accurately but that it should only be charged to clients on a case‑by‑case basis, and not hedged. Slightly fewer (40%) viewed it as a critical funding measure that must be accurately charged to clients and hedged. 

Florent Kbodjedo of the National Bank of Canada commented that, while his bank does not have MVA currently, he sees it as “nice to have”, for the counterbalancing effect of counterparty risk. 

Cowan explained that, from the quant perspective, calculating MVA is not one of the simpler measures, adding: “Sometimes there are important risk factors that drive initial margin and are missing from XVA systems – such as foreign exchange basis risk and volatility.” 

In a second poll, the audience shared its views on the appropriate use of capital valuation adjustment (KVA) by the XVA desk. Most (38%) said it was critical in pricing pre-execution, but should not be held on the balance sheet or directly risk‑managed. One-quarter of the audience (25%) said it was critical in the pricing of lifetime trade returns pre-execution, as well as directly managed post-execution as an on‑balance‑sheet value adjustment. Another 25% said expected capital consumption should not be priced in at trade level, but managed on a realised basis at portfolio level. 
 

Technology and techniques 

Technology is crucial for effectively managing and modelling XVA, with new developments making the task less onerous, explained Cowan: “XVA continues to present a technical challenge due to the massive amounts of valuations required across the whole portfolio. Having scalable and cloud-based architecture for calculations, either on-demand or in real time, is key. Leveraging cloud computing allows you to generate calculations whenever you need them. This can usually allow you to run your systems much more cheaply than having hardware and IT teams available in-house. Leveraging the latest tech stacks is a big step forward in the XVA space.” 

In the final poll, the audience considered how the higher interest rate environment had affected their use of physical assets as collateral for variation margin (VM). Most (40%) said that the majority of VM was cash, followed by one-quarter (25%) who reported a notable increase in physical assets posted/received, with the cheapest‑to‑deliver option having a marked impact on XVAs. 
 

Regulatory change

Looking ahead, Campbell-Coleman said: “In terms of what is on the regulatory agenda, people are mainly wondering if there will be big changes following the collapses of Credit Suisse and Silicon Valley Bank – but that will take time.”

In the medium term, Kpodjedo highlighted the treatment of credit valuation adjustment (CVA) within the Fundamental Review of the Trading Book as problematic for the XVA desk. This is due to a potential misalignment between accounting CVA and regulatory CVA. 

“If you start hedging the regulatory CVA, you may have a mismatch with accounting CVA,” he explained. “This disconnect can potentially lead to suboptimal index hedging.” 

Cowan agreed this is a key issue, adding that firms will also need to work out how to factor CVA capital into KVA calculations going forward. “The standardised approach to credit valuation adjustment [SA-CVA] compounds the problem – as well as mark-to-market sensitivity, we’re talking about CVA sensitivities projected over the lifetime of your portfolio,” he said. “A prudent approach would be a required focus on the under‑hedged part of your SA-CVA.”

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Watch the full panel discussion New developments in XVA: an inside view on bank strategy in a changing world

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