In sight quantifi newsletter issue 04
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Quantifi has announced its major release version 10.2, featuring significant enhancements in asset coverage and support for various financial instruments, and has recently won the 'Risk Management Technology of the Year' award, reflecting its innovative capabilities and customer satisfaction. The document also discusses the complexities of credit value adjustment (CVA) and debt value adjustment (DVA) within banking earnings, highlighting recent trends and the impact of credit spreads on these adjustments. Additionally, the conversation with Channel Capital Advisors addresses the ongoing challenges in the financial sector, emphasizing the need for long-term solutions amidst government reliance and market instability.
In sight quantifi newsletter issue 04
- 1. IN NEWSLETTER ISSUE 04 SIGHT 2 012 CVA, DVA AND Q4 BANK EARNINGS Also in this issue: Quantifi Wins Coveted Risk Management Technology Award Page 3 Conversation with Brian Naini, Channel Capital Page 6
- 2. MESSAGE NEWS FROM Quantifi Release Version 10.2 Version 10.2 is Quantifi’s next major release. THE CEO This release comprises of several major enhancements including increased asset coverage, enhanced existing support for FX and hybrids, improved support for Quantifi has had a great start to 2012, having recently won intra-day risk and additional out-of-the box Risk Magazine’s ‘Risk Management Technology of the Year’ data interfaces. award. This is Risk’s premier vendor award and one that we feel is a significant accomplishment given the competition, Quantifi Wins Coveted Risk which includes the largest, most established vendors in this Management Technology Award space. We received this award with accolades for our first- The Risk Management Technology Product to-market support for OIS discounting, and CVA/DVA, ease of the Year award recognises excellence of implementation and customer satisfaction. This is a strong and innovation of technology firms in the testament to the strength of our ongoing research and our close fast-changing risk management and OTC partnership with clients, who ultimately are the final judges derivatives businesses. “We are delighted that of what we do. Particularly rewarding was the feedback from Quantifi continues to receive a high level of clients including Jan-Alexander Posth, Head of Fund Derivatives industry recognition. This award means a great at LBBW who said “Quantifi Risk was quickly installed on our deal to us, especially considering our front desk, though full integration with back-office systems” and size compared to other firms operating in “Important benefits the technology has brought are accuracy our space,” comments Rohan Douglas, of results, speed of calculation and an intuitive interface” while CEO of Quantifi. Varden Pacific’s co-founder, Shawn Stoval said “Their analytics are superb. And our risk system runs fluidly each night — just VTB Capital, Selects Quantifi for OTC Analytics, like it is supposed to”. Our support also received top ratings Pricing and Portfolio Valuation with Shawn describing Quantifi’s support as “top notch,” while “We looked to implement a portfolio valuation Alex Posth, LBBW, says it is “outstanding.” solution that increased accuracy and flexibility As we progress into 2012 we see many of the same challenges while at the same time minimised operational which are familiar from 2011. Regulator, political and market risk,” said Stathis Margonis, Head of Credit uncertainties make for a challenging environment. For many Derivatives and Hybrids Trading of VTB market participants this has meant deferring key strategic Capital, “Quantifi’s expertise and ability to decisions until uncertainty reduces. 2012 may be the year deliver a robust tool set for OTC analytics and that this reaches a tipping point and where strategic decisions client pricing were key factors in our decision. are made and implemented based on an increasingly clear Quantifi has already reduced our operational new market paradigm. This will be an environment where costs and increased our business flexibility by investments in trading and risk management infrastructure allowing us to focus internal development on will help determine the winners. Effective management and other strategic projects.” allocation of capital based on risk and return along with a cost-effective, flexible infrastructure will be key competitive advantages. EVENTS This month we also roll out our next major release – version 10.2. Quantifi Seminar: Counterparty Risk and CVA, This release increases asset coverage, enhances existing support What’s New? New York City, February 15th particularly for FX and hybrids, improves support for intra-day Quantifi & PRMIA have teamed up to present risk and provides additional out-of-the box data interfaces. This an interactive seminar on Counterparty Risk & release is just three months after our last major release and CVA, with experienced practitioners offering their demonstrates our unique pace of innovation and our ability to opinion on all matters related to this hot topic. respond rapidly to client needs. We look forward to 2012 as a year of potential as well as risks and one where we continue to make a difference to our clients’ competitiveness and bottom line. ROHAN DOUGLAS, Founder and CEO 02 | www.quantifisolutions.com
- 3. Quantifi Wins Coveted Risk Management Technology Award Risk Management Technology Product of the Year: Quantifi Risk Over the past few years, pricing practices have changed portfolio of credit products in 2007 — it says Quantifi was dramatically, in particular to capture the credit value the only supplier that could meet its requirements. The adjustment (CVA) that reflects the chance a counterparty bank licensed the software in early 2008 and was able to will collapse while owing money on a trade, and to install it quickly on its front desk, although full integration discount collateralised trades at an overnight indexed with back-office systems and the addition of a high- swap (OIS) rate determined by the currency of the performance computing grid took some months longer. collateral — a simple enough shift in theory, but one that has forced the industry to draw up a standardised “In the specialised area of credit valuation, Quantifi had no collateral agreement in an attempt to remove some of the real competitors at the time,” says Jan-Alexander Posth, complexities involved. head of fund derivatives at LBBW. The bank has since extended its use of Quantifi across other business lines With industry practice changing so rapidly, technology and to risk management. The most important benefits the providers also have to be nimble when creating or technology has brought are accuracy of results, speed of updating pricing and risk management tools that reflect calculation and an intuitive interface, says Posth. the new reality. Gone are the days when a bank could acquire front-office or risk management systems and Much smaller institutions have also turned to Quantifi allow a couple of years for implementation — the need for for help, including San Francisco-based Varden Pacific accurate pricing and valuation is urgent. Making matters — a hedge fund start-up focused on fixed income, worse, banks have also reined in their spending, so a particularly opportunities in corporate-backed structured primary criterion for new technology is cost-effectiveness. credit. Launched in early 2011, the firm says it needed sophisticated pricing and risk analytics that would match New Jersey-based Quantifi scores highly on all the above, those used at large banks, but from a system that did not the firm’s clients say. It was among the first technology require the support of a large bank’s IT team. It chose suppliers to support OIS discounting, CVA — and the Quantifi, and the implementation took just 18 hours over latter’s more controversial twin, debit value adjustment three days. The fund uses the system for pricing, booking (DVA). Founded in 2002, it cemented its reputation for trades, daily risk reports, what-if analysis, profit and loss accurate pricing with its initial credit pricing library in calculations, historical analysis and tracking jump-to- 2006, and has maintained the quality while branching out default numbers. across other asset classes such as interest rates and foreign exchange. Its technology is relatively light and slots into a “The most important benefit the bank’s infrastructure quickly. And, while a number of banks have implemented Quantifi Risk on an enterprise level, it technology has brought are accuracy also offers a cost-effective option for individual business of results, speed of calculation and units or smaller institutions. an intuitive interface” “CVA, DVA and OIS discounting is the way the market trades nowadays. They permeate everything – not just interest “After using the software for the better part of a year, I can rates, but also foreign exchange, credit and other products. confirm their analytics are superb. And our risk system runs Whether trades are collateralised or uncollateralised, it’s fluidly each night – just like it is supposed to,” says Varden the same story — what is your funding cost and what is Pacific co-founder Shawn Stoval. your credit exposure? Whether you translate that into OIS discounting, CVA or funding value adjustment – it’s all very Finally, given the complexity and changeability of much part of what you need to price on the desk today,” today’s markets, institutions want more than just says Rohan Douglas, Quantifi’s New Jersey-based chief software products from their suppliers – they want executive officer. As of December last year, the firm had ongoing guidance and support. Quantifi clients praise more than 120 clients across the sell and buy sides. the company’s balance of business and technological expertise. Overall, Stoval describes Quantifi’s support as One of those is the Stuttgart-based Landesbank Baden- “top notch”, while Posth of LBBW says it is “outstanding”. Württemberg (LBBW), which went looking for a technology framework that would provide consistent valuations for its First appeared in ‘Risk Magazine’ January 2012 www.quantifisolutions.com | 03
- 4. COVER STORY CVA, DVA AND Q4 BANK EARNINGS DAVID KELLY, Director of Credit and DMITRY PUGACHEVSKY, Director of Research, at Quantifi Credit Value Adjustment (CVA) is the amount entitled ‘CVA, DVA and Bank Earnings’, subtracted from the mark-to-market (MTM) value of which attempted to dissect the Q3 DVA results and derivative positions to account for the expected loss make some predictions about Q4. Here, we will analyze due to counterparty defaults. Debt Value Adjustment the recently reported Q4 DVA results. (DVA) is basically CVA from the counterparty’s perspective. If one party incurs a CVA loss, the other Q3 DVA Review party records a corresponding DVA gain. Most banks reported large DVA gains for the third quarter due to significantly wider credit spreads. The following DVA is the amount added back to the MTM value to table displays Q3 DVA results reported by the five largest account for the expected gain from an institution’s U.S. banks: own default. Including DVA (in addition to CVA) is intuitively pleasing because both parties theoretically Jun CDS DVA Gain report the same credit-adjusted MTM value. DVA is also Bank (bps) Sep CDS ∆ CDS (bln) controversial because institutions record gains when their credit quality deteriorates, creating perverse incentives, BAC 158 426 268 1.700 and the gains can only be realised on default. C 137 319 182 1.888 Accounting rules mandate the inclusion of CVA in MTM GS 137 330 193 0.450 reporting, which means bank earnings are subject to CVA volatility. DVA is also accepted under the accounting JPM 79 163 84 1.900 rules and banks that include it, and by doing so must MS 162 492 330 3.400 continue to include it going forward, add their own credit spread as a source of earnings volatility. To mitigate CVA volatility, as well as hedge default risk, many banks buy Q4 DVA Results CDS protection on their counterparties. Hedging DVA is We used the reported Q3 DVA results above to estimate not as straightforward. Since DVA increases as the bank’s Q4 DVAs. These estimates, along with the actual change in credit spread widens, it is equivalent to the bank being CDS spreads during Q4 are provided in the following table: short its own debt. Therefore, hedging involves buying the bank’s own bonds or selling protection on highly Est. DVA correlated institutions, i.e., other banks, since they can’t Bank Sep CDS Dec CDS ∆ CDS Gain (mm) sell protection on themselves. BAC 426 413 -13 (82) DVA became a hot topic when banks announced 2011 C 319 285 -34 (353) Q3 earnings, due to the magnitude and direction of the amounts. Ironically, where large DVA gains substantially GS 330 332 2 5 impacted earnings, the bank’s outlook improved, JPM 163 147 -16 (339) thereby tightening its credit spread and generating DVA losses. This article is a sequel to a previous report MS 492 421 -71 (732) 04 | www.quantifisolutions.com
- 5. Commentary The estimated DVA in the last column is based on a Using bond spreads instead of CDS would seem to simple ratio of the change in CDS spread for Q4 divided compromise a key benefit of including DVA in the by the change in CDS spread for Q3 times Q3 DVA. valuation of derivative positions. Including DVA along For example, Bank of America’s $1.7bln DVA gain in Q3 with CVA, also called ‘Bilateral CVA’, results in both parties came from its credit spread widening 268bps, so 13bps reporting the same credit-adjusted value for the position. tightening in Q4 should roughly equate to a $82.5mln loss Using bond spreads compromises that because each (13/268 * 1.7bln). Of course, these crude estimates ignore party typically uses the other party’s CDS spread, not the changes in portfolio composition and changes in risk bond spread, to price CVA. The reason is that CDS is a factors other than the bank’s CDS spread, such as interest more effective means to ‘replicate’ (hedge) credit risk. On rates, FX, commodity & equity prices, volatilities the flip side, DVA is more efficiently replicated by buying and correlations. the firm’s own bonds since the firm cannot sell protection on itself. In fact, Morgan Stanley reported that they did Since the CDS spreads for all banks except Goldman Sachs buy back some debt during Q4 on their earnings call. tightened, we would expect to see DVA losses for the quarter. The next table shows actual DVA results reported To compound the problem, the basis between bond by the banks and differences from the above estimates: and CDS spreads, generally wide at the end of Q3, dramatically widened for Citigroup and Morgan Stanley during Q4. The bond-CDS basis is a measure of liquidity Est. DVA Gain Actual DVA Bank Difference risk, as reflected in the diverging bid-offer spreads for (mm) Gain bank-issued bonds during Q4. Due to the widening basis, BAC (82) (474) 392 there has been increased interest in pricing liquidity risk through a Liquidity Valuation Adjustment (LVA). Roughly C (353) (40) (313) speaking, LVA is the difference between DVA calculated GS 5 – 5 with CDS spreads and DVA calculated with bond spreads. JPM (339) (567) 228 “Although Q4 DVA results were MS (732) 216 (948) relatively small, there could be Aside from JPMorgan, the estimated DVAs appear substantial losses in the future significantly off, although the differences are less than 4% of implied expected exposure for each bank. Certainly, given the relatively high spreads.” simplifying assumptions about constant portfolios and static underlying market risk factors are responsible for Even with LVA, the asymmetric pricing problem persists some of the differences but the choice of using CDS unless LVAs for both parties are exactly the same. There spreads, as opposed to bond prices, as the key input to is also research challenging the efficacy of buying one’s the DVA calculation is a critical issue. bonds to hedge DVA. The bottom line is that a standard or ‘best practice’ for pricing and hedging DVA has not yet In reality, banks use credit spreads derived from their been established and we should continue to see swings bonds (or some combination of bonds and CDS) to in this component of bank earnings. calculate DVA. The table below shows recalculated DVA estimates using the change in 5-year credit spreads Although Q4 DVA results were relatively small, there implied from bonds. could be substantial losses in the future given the relatively high spreads. For example, if the increases Est. DVA in spreads that occurred during Q3 of 2011 were Sep 5Yr Dec 5Yr Gain reversed, those large DVA gains would turn into roughly Bank Bond Bond ∆ Bond (mm) equivalent losses. In a tougher regulatory environment BAC 495 480 -15 (95) it is reasonable to expect that bank earnings will remain constrained and it is possible that future DVA losses could C 305 310 5 52 entirely offset earnings even as credit quality improves. GS 330 330 0 – JPM 233 220 -13 (294) MS 485 505 20 206 The DVA estimates using bond spreads are generally much closer. Notice that there is significant basis between the bond and CDS spreads in most cases. We will outline why banks use bond spreads and implications of the bond-CDS basis next. www.quantifisolutions.com | 05
- 6. FEATURE Conversation Brian Naini with Chief Risk Officer What is the history and background of ECB’s response has been to provide increasing amounts your company? of liquidity in the market. “Channel Capital Advisors LLP (CCA) is a UK based Given the banking sectors reliance on governments since investment manager focusing on credit risk and 2008 and the extent of the government bond holdings structured finance transactions. CCA was established by the banks, an unstable negative feedback loop has in 2006 by its founders and a consortium of European developed that needs to be dealt with. commercial banks. In 2007, CCA launched Channel Capital PLC (CC PLC), an Irish based operating company. Long term solutions would require a combination of CC PLC raised capital by issuing long dated junior and deleveraging the economy, debt writedowns, austerity senior rated notes, and secured counterparty ratings measures and painful structural reforms to stimulate from SP and Moody’s. Despite difficult market growth and reduce fiscal deficits. These solutions take conditions from mid 2007 onwards, CC PLC was time and would require political will and public support successful in originating and managing over USD 10 neither of which is guaranteed.” billion of portfolio credit transactions and has generated attractive returns for its investors. More recently, CCA What key challenges and /or opportunities does the has been exploring opportunities in the regulatory current environment bring to your business and how capital space as well as loan portfolio intermediation and do you intend to manage them? structuring term liquidity transactions.” “The banking sector will have to deleverage to comply Over the course of the past 12 months what do you with the new capital requirements. This would be done consider to be the most significant development in through sale of non-core businesses, asset roll offs, asset the credit markets? sales, raising additional capital or risk transfer to other parts of the financial system. “Markets have become increasingly concerned with the health of peripheral European government finances and CCA can offer solutions to efficiently transfer credit governments’ progress in this regard. Lack of market and or liquidity risk from bank balance sheets to investors. confidence has led to higher interest on government Long term investors can benefit from the increasing bonds, which has made the task of reducing the debt/ demand for capital to earn equity type returns by GDP ratio amid sluggish economic growth more difficult. assuming credit risk of good quality portfolios. 06 | www.quantifisolutions.com
- 7. CCA has also been active in intermediating loan portfolios between banks and end investors and has also provided long term funding solutions. We expect to be able to do more of these types of transactions as “Cost of implementing the the underlying rationale from the banks’ perspective will persist.” regulations will put pressure on buy side profit margins What is your reaction to the changing regulatory landscape. How will it impact the buy-side? especially for the small to “Cost of implementing the regulations will put pressure medium size funds.” on buy side profit margins especially for the small to medium size funds. Operational and business risks of starting a new fund or running an existing fund below a sizeable threshold will increase. This will allow larger investment managers with better economies of scale to capture a larger market share of assets under management. Some of the costs of the new regulations This has led to a risk on / risk off investment environment will most likely be passed on to the investors, putting where short term tactical positions are taken by investors further pressure on investment returns in an already without much of a long term conviction. Given the difficult and uncertain environment.” prevailing uncertainty, this tactical approach with close monitoring of risk is prudent and I expect that it will Do you see a world where investors should seek continue for a while longer. However, the valuations safety, or a world where investors should look to are cheap in some markets, at least relative to historical take on risk to capitalise on significant medium / measures. Investors with longer horizons and appetite long-term opportunity? for some volatility might be able to take advantage of these opportunities.” “The choice ultimately depends on each individual’s risk profile, objectives and financial position. The environment Looking ahead, what market development do is unusual in that persuasive arguments in favour of you anticipate? diagonally opposite outcomes can be made. References to bi-modal distributions are becoming more common. “I think the deleveraging of the financial sector, For example, there is not much of a consensus whether government and households balance sheets will we will have very high or very low inflation in the coming continue. Governments will try to, at least partially, years. Similarly, it can be argued that bonds are expensive inflate their way out of the debt load. The Eurozone but they could also conceivably stay at current low yields will continue to experience stress. Default of one or more for an extended period as it is the case with Japan. Similar countries is widely expected. I would not rule out the points can be made for commodities, equities, real estate case where one or more peripheral countries, faced with etc. The collective impact of fiscal and monetary policy, unpopular austerity measures, try to exit Euro. protracted deleveraging in the economy, new regulations across various jurisdictions, political considerations Finally, I am going to go on a limb and think it possible in Europe and the possibility of Euro break up is that some basic, unleveraged forms of credit products, highly unpredictable. such as simple tranched corporate portfolios, will make a comeback in a few years time once central clearing platforms are more developed, the risk management infra-structure of the banks and investors are more sophisticated and banks start switching from survival mode to business expansion mode. These products “Operational and business could serve an economic purpose if properly integrated risks of starting a new fund in a truly diversified portfolio. A parallel could be drawn with interest rate derivatives in mid 1990s when after or running an existing fund some market disruptions and well publicised end user below a sizeable threshold losses, the products made a strong comeback albeit with some never to be seen again casualties such as Libor will increase.” squared and cubed based products.” a Quantifi client www.quantifisolutions.com | 07
- 8. Quantifi Launches Quantifi Releases Counterparty Risk and CVA Portal Version 10.2 Version 10.2 is Quantifi’s next major release. CounterpartyRiskManagement.org is a free online information This release comprises of several major source for professionals active in counterparty risk management enhancements including increased asset and credit valuation adjustment (CVA). It is designed to provide coverage, enhanced existing support for FX timely industry news, research and information on important is- and hybrids, improved support for intra- sues surrounding counterparty risk. day risk and additional out-of-the box data interfaces. A sample of new features: • New support for money market securities, global bond futures and credit notes with defaultable funding • Significant improvements to counterparty risk management including fast CVA VaR, AMC pricing of exotics, and improved marginal pricing tools • Product enhancements for FX option modelling, hybrids modelling, and customised cashflow support • Improved and simplified intra-day risk Main features include: generation and reporting • Expanded data management capabilities • The latest news and data related to counterparty risk and CVA to simplify data integration • Access to information from leading analysts, such as Aite, • Celent and Tabb Group Interactive blogs and commentary for exchanging ideas Whitepapers and information • CVA, DVA and Bank Earnings • Overview of key regulatory themes, such as Basel III, • How the Credit Crisis has Changed EMIR, Dodd-Frank, etc. Counteraparty Risk Management • Insightful videos from leading financial reporters and market practitioners, paired with a YouTube channel • OIS CSA Discounting • A comprehensive list of ‘Who’s Who’ in the industry • Challenges in Implementing a • Regular e-newsletter sent to subscribers Counterparty Risk Management Process • Evolution of Counterparty Credit Risk Request a copy: enquire@quantifisolutions.com ABOUT QUANTIFI Quantifi is a leading provider of analytics, trading and risk management software for the global OTC markets. Our suite of integrated pre and post-trade solutions allow market participants to better value, trade and risk manage their exposures and respond more effectively to changing market conditions. Founded in 2002, Quantifi is trusted by the world’s most sophisticated financial institutions including five of the six largest global banks, two of the three largest asset managers, leading hedge funds, insurance companies, pension funds and other financial institutions across 15 countries. Renowned for our client focus, depth of experience and commitment to innovation, Quantifi is consistently first-to-market with intuitive, award-winning solutions. enquire@quantifisolutions.com | www.quantifisolutions.com Europe: +44 (0) 20 7397 8788 • North America: +1 (212) 784 6815 • Asia Pacific: +61 (02) 9221 0133 Follow us on: @ Quantifi © Quantifi Inc. All rights reserved. Quantifi, Quantifi Risk, Quantifi XL, Quantifi Toolkit, Quantifi Counterparty Risk, Quantifi CVA are trademarks of Quantifi Inc.