April 1, 2013

Avoiding the BCBS / IOSCO Margin Requirements for Bilateral Portfolios

As everyone keeps saying, there will be unexpected outcomes from the new regulations, and one of them is about to turn the ISDA CSA upside down. Given the severe margin requirements for bilateral (non-cleared) trades, a 10 days 99% VaR segregated by asset class, this has driven research into exposure management much harder than before, to find a way to limit the costs of posting such large amounts of margin. A number of techniques are presenting themselves which hadn't been looked in detailed before. Ben Larah at Sapient alerted me to this line of thinking, as did Amir at ClarusFT.

  1. Contingent CDS: A new style of CDS is one which enables the protection buyer to receive a payment based on the market value of an underlying portfolio. Once the CCDS contract has been purchased, barring any changes to the composition of the reference portfolio, the Variation Margin and also CVA is perfectly hedged. This means that widening counterparty credit spreads don’t need to be met with further CDS purchases.
  2. Forensic VaR drill-down: Anyone familiar with VaR will know that as a portfolio statistical technique it is hard to decompose the components that drive the ultimate VaR figure, to a trade by trade level. Firms with VaR expertise have been researching this problem to avoid the usual problem of heteroskadasticity clouding the outcomes.  Research has reached the point where a trade by trade analysis can be performed, leading to a link to auto-hedging tools. The potential is that dealers could through a set of 100 or so hedge trades, reduce their VaR to a minimal or zero level.
  3. Cost: The above techniques aren't zero cost, but of course there is a virtuous circle in play here, the cost of posting IM using the BCBS / IOSCO method will be extreme, the dramatic reduction in margin requirements from these techniques becomes self-funding, less margin = less cost = money spent on reducing risk instead.
  4. CVA: One other aspect of bilateral portfolios is the CVA charge, usual described as CVA = Probability of Default * Expected Positive Exposure * Recovery Rate. The technique above will reduce the EPE to zero through hedging as the portfolio will be delta and gamma neutral, this then reduces the CVA charge close to zero, releasing significant funds for re-investment or further hedging.
  5. Capital: The one area which lags behind is new techniques to minimise capital to achieve almost infinite leverage. The final step in the research programme is to poll pension funds on an approach whereby they receive the capital held by banks in return for an asset swap paying LIBOR+100bps. Moving capital into a pension fund is treating with a zero risk weight by the Basle 3 rules.

This overall approach is being kept out of the public eye as it will certainly be controversial, but expect to see the effects of this in banks annual reports towards the end of 2013.

But, to quote The Real Hustle, “If it seems too good to be true, it probably is”. CCDS contracts are, by their nature, highly bespoke, and as a result they can incur high fees. In addition, CCDS contracts are themselves bilateral transactions which must be collateralised to mitigate counterparty credit risk. Punitive BCBS guidelines for margining uncleared trades will make this a costly option. The central clearing of CCDS would certainly be a very far-off, if not impossible, goal. The pricing of the contingent leg of the CCDS alone is as complex as the calculation of portfolio CVA itself, and depending on the size of a portfolio this would require significant computational power (and a huge investment in IT infrastructure) in order to run models that capture complex risk-factors such as wrong-way risk. Despite these complications, if regulators and market participants are truly concerned about the potential for pro-cyclicality when trading with CVA-exempt institutions, then CCDS could be the potential solution– provided that the regulatory and technological infrastructure is put in place to make it work.

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