July 4, 2013

CVA and CDS | Proxy Problems

As CDS contracts continue to be perceived as the 'bad guys' in global finance, regulators are limiting their availability to be used as hedging tools, even when it's perfectly OK to use derivatives from other asset classes for a similar purpose. A Risk Magazine article, published today, reports that US-based regulators will not exempt any derivatives-counterparties from CVA requirements. This may apparently squeeze out US-based banks, who will face stiff competition from European banks that are exempt from charging CVA for their corporate, sovereign, and pension fund counterparties to derivatives contracts. The particular section of the article I want to highlight relates to the proposed US treatment of single-name CDS proxy trades, i.e. single-name CDS contracts being used to hedge CVA, but whose underlying reference entities don't exactly match the derivative-counterparty:

"The final rule states that barring the use of single-name proxy credit default swaps (CDSs) is an important limitation because of the significant basis risk that could otherwise result. The rule only allows the recognition of single-name CDSs [whose underlying reference entity exactly matches the derivative counterparty], single-name contingent CDSs and index CDSs."

In my view, this is problematic for several reasons:

  • If there's no liquid CDS market on the underlying counterparty, then using a similar proxy-name may be the best option for maintaining a CVA hedge. In fact, if the CDS on the proxy is much, much more liquid than CDS on the actual counterparty, then one could argue that the proxy is the better hedge.
  • Even if an institution uses a CDX to hedge counterparty CVA, they'd still need to manage the (potentially significant) basis risk between the counterparty and the reference entities in the CDX basket. So the point about "significant basis risk" is moot; there'd be basis risk in either case! (Of course, there are tangible benefits for using a CDX as the hedging instrument, such as better liquidity, but I don't think that anything to do with basis-risk is one of them.)
  • Using similar underlying single-names as proxies for hedging and pricing is perfectly acceptable in other derivatives markets, so why not for single-name CDS?

I'd like to dive more into my third point. For equity derivatives, several third-party valuations vendors are proxying the implied volatility surfaces for liquid single-name equity options to price illiquid single-name equity options, as long as there's sufficiently high correlation between historical movements in the two spot markets. This methodology doesn't appear to fall foul of any regulations (from a fair-value accounting perspective they'd simply be considered IAS 39 level 2 or 3 valuations). If one can use proxy information for pricing illiquid equity options, then it stands to reason that one can also base hedges for these positions on pricing information derived from a proxy underlying. Therefore, it does not seem fair that CDS are held to a higher standard than other derivatives. -Ben L.

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