Asymmetry of CSAs Causes FVA Costs
Asymmetry of CSAs Causes FVA Costs
There has been some confusion recently over Funding Value Adjustment (FVA). On April 29th, Risk Magazine reported that dealers were charging clients for FVA on collateralised trades, due to the quality and fungibility of collateral being posted by the client. To appreciate why this is happening, one needs to understand dealers’ funding operations when making derivatives markets.
This article provides a simple explanation of the situation by reviewing the high-level fundamentals of FVA, explaining how changes in derivatives markets since the financial crisis have impacted dealer funding operations, and finally putting the recent situation into this context.
What is FVA?
FVA stands for Funding Value (or Valuation) Adjustment. It is the difference between the risk-free value of an uncollateralised portfolio of derivatives, and the same uncollateralised portfolio valued using the dealer’s cost of funding. FVA takes into account the dealer’s cost of funding for the entire lifecycle of the por tfolio.
Why is FVA a relatively recent concern?
Prior to the 2008 financial crisis, LIBOR was assumed to be a suitable benchmark for the risk-free interest rate. It was also assumed that markets were sufficiently liquid that dealers could always fund themselves at the risk-free rate.
When dealers posted collateral in the form of variation margin (VM) as the value of their OTC derivatives portfolios moved against them, the LIBOR curve took a dual role:
- LIBOR was assumed to be the overnight cost of borrowing funds to post as collateral
- The interest received by the bank on the posted collateral (called Price Alignment Interest, or PAI) was calculated using LIBOR
The effects of 1 and 2 cancelled each other, so the market value of the portfolio remained indifferent to the cost of funding collateral.
The events of 2008 changed this. After LIBOR-OIS spread widened significantly during the Lehman crisis, the market started to adopt OIS (e.g. Fed Funds in the US) as the interest received on posted collateral. However, the cost of funding the collateral started to vary depending on the credit quality of the dealer borrowing the funds. The quantification of this cost of funding is the FVA.
How does FVA arise in practice?
For simplicity, we shall assume a portfolio containing a single dealer - client-counterparty trade.
When a dealer hedges their client-counterparty trade in the interdealer market, if the client-counterparty posts collateral and this collateral can be rehypothecated to the hedge-counterparty (assuming perfect, symmetrical collateral and an identical hedge to the original trade), then there is no FVA cost (see Diagram 1).
However, if the dealer - client-counterparty trade is uncollateralised then this impacts the dealer when they are in-the-money with the client-counterparty. This means that they are out-of-the-money with the hedge-counterparty. Since they are not receiving collateral from the client-counterparty, they must borrow the required VM from their internal treasury, for which they will be charged their own cost-of-funds. This is where FVA term known as Funding Cost Adjustment (FCA) arises.
To compensate for having to borrow at own cost-of-funds from the internal treasury whenever they are in-the-money, the dealer will typically pass FCA costs onto the client-counterparty for uncollateralised trades (see Diagram 2)
The converse situation, where the dealer is out-of-the-money with the client-counterparty, gives rise to a Funding Benefit Adjustment (FBA). Given that the dealer now is in-the-money with the hedge-counterparty, it is assumed that the dealer can rehypothecate the VM received from the hedge-counterparty and lend it to their treasury, thereby receiving a funding benefit.
So why are dealers charging FVA, even if trades are collateralised?
Now we arrive back at our original problem. This is because the simple diagrams above assume perfect collateral and deal symmetry between dealer - client-counterparty and dealer - hedge-counterparty. In particular, the diagrams assume that:
- The terms of the Credit Support Annexes (CSAs) governing the collateral mechanics (e.g. collateral quality, thresholds, minimum transfer amounts (MTAs), rounding, etc.) are the same
- The terms of the dealer - client-counterparty trade are identical to those of the dealer - hedge-counterparty trade
In reality, the asymmetry between CSA agreements can mean that the dealer is willing to accept certain types of collateral (such as corporate bonds) from their client-counterparty, but the hedge-counterparty won’t accept this collateral from the dealer! In addition, it may be difficult for the dealer to fund the illiquid collateral (such as corporate bonds) in the repo market to generate the cash needed to post to the hedge-counterparty, and therefore the dealer is forced to borrow from their internal treasury desks - a situation which is similar to that of an uncollateralised swap.
This article was first published in edition 3 of Rocket, our magazine. Download your copy here, or save your address in your profile to receive a printed copy.
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