There's been some recent news surrounding EU legislators exempting corporates, sovereigns and pension funds from mandatory CVA capital requirements under CRD IV (see article). Arguments for these institutions' exemptions apparently stem from their current exemption from EMIR's mandatory clearing requirements. This has understandably led to fresh concerns over pro-cyclicality, which were first raised when sovereign counterparties were originally exempt from central clearing. To briefly summarise the issue:

• A bilateral counterparty's credit spreads increase
• Therefore portfolio CVA  increases
• CVA exposure is dynamically hedged using CDS, and therefore more CDS protection is purchased referencing the counterparty
• This increase in demand for protection further widens the counterparty's credit spreads…

And the cycle continues. However, such fears over pro-cyclicality can be alleviated through the purchase of a contingent CDS (CCDS) contract. CCDS contracts behave in a similar manner to vanilla CDS contracts. However, instead of referencing a notional of corporate or sovereign debt, CCDS can reference the market value of a portfolio of derivatives. Hedging CVA using CDS is an example of dynamic hedging, whereby a portfolio must be rebalanced to reflect its changing sensitivity to credit spreads. CCDS contracts, however, are static hedges against CVA. Once the CCDS contract has been purchased, barring any changes to the composition of the reference portfolio, the CVA is perfectly hedged. This means that widening counterparty credit spreads don't need to be met with further CDS purchases, and therefore the downward spiral is broken.

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.

Ben Larah.

P.S. Editor: The latter section (Real Hustle onwards) I re-used for a bogus April 1st post, please ignore the bogus post, as the commentary above is legitimate, Ben wrote this prior to April 1st.