Today, I want to discuss about an article that came out September 2nd, of Risk Magazine titled Replacement Costs Add to OTC Pricing Upheaval. If you haven’t read it and you’re in the market it’s definitely a must read. It’s introducing basically rating triggers, back again and the development of RVA. For those who are unfamiliar with rating triggers, they’ve came back into the spotlight really around Enron and then from there, were highlighted through the rating agency reform act of 2009. We’re now seeing them again and there’s a lot of interesting positions on this in terms of the role of rating triggers within OTC derivatives and valuations.
Understanding RVA Risk
So what I want to jump into a little bit is, we all know what rating triggers are. I explain this concept of RVA and how and why it is so controversial? So the replacement valuation adjustment is really a metric to measure downgrade triggers. The downgrade triggers typically clause you would find in the CSA, or credit support annex, that is negotiated between banks and their counter party clients. What the clause really dictates is in the event of a downgrade to a certain rating level for that bank. The counter party, typically the end client has the ability to force the close out. The bank will have to close out that position and replace that position with another bank. Which means they actually have to find another counter party to step in and take over that transaction.
Now, from a risk prospective it’s hard to measure, because we take into account potential down fault triggers. It takes into account the likelihood of defaults. The likelihood of the end client exercising that option to force closeout and replacement. The ultimately, a big part of this article, which is really well written around this, is the fact that these downgrade triggers exist typically for concentrated sets of banks around different types of asset classes. So, an example in the article was around inflation swaps which has a lot of the banks in the U.K. that have built in downgrade triggers with their clients. The fact remains that in the event of a financial crisis, such as the one we’ve seen in 2008, most of these banks will go through downgrades and a lot of these triggers can then be kicked into effect. As a result you would see bid ask spreads explode as a result of counter parties and banks trying to replace a lot of these positions.
How is the market involved? You think about a couple years ago, your average bank rating was probably range. We’ve seen continued pressure, downward rating pressure, and the triggers were really coming in at that range. There’s not a lot of room here, especially if you’re looking at any point and time of multi-notch downgrade. So it’s clear on a systemic risk but how should practitioners be thinking and preparing as for those institutions that might be getting closer to a trigger or in the event of a multi-notch downgrade. What kind of defense mechanism can you have in place?
So you can think of it from the end client side, you can think of it from the bank side. If you look at the history of why these downgrade triggers exist in the CSA’s, it was really to gain market share. So during times where these banks were highly rated, it was a free option that was offered to end clients to win market share. I don’t think there was really a lot of work around, or belief that many years from those initial transactions. We’d be at the rating levels that, we see banks at today. So that was really not something that was actively managed. Now, it comes into the forefront because we are in a different environment. Banks are at much lower ratings than they were in the past decade and as a result, banks have to manage this potential risk. End clients, who are still looking to be able to exercise these options or be able to still embed them in new swap transactions, are looking to have this type of exit strategy.
How do banks manage this today? That’s a big question mark. So a lot of inputs go into this. We’ve discuss about in the past calculating CVA and DVA and those require some assumptions. RVA requires even more assumptions. It basically is managing and estimating default likelihood of the own bank. You can do that through bond spreads and credit spreads. You have to also measure the likelihood of your end client actually exercising that option. They may choose not to do that – or to do that depending on the benefits for them. They may find it very difficult to find that estimation. I have done a lot really around the release of the new standard CSA, and reduction of optionality. Has this been addressed in the new standard CSA? In the new standard CSA you don’t actually see much on the downgrade triggers.
We’ve moved to a smaller set of currencies that can be posted as collateral. A smaller set of eligible collateral securities that could be posted. So we’re reducing some of the optionality around the currency that can be posted and certainly around the downgrade rating triggers. But as you said, the standardized CSA is going to take a while to roll out. It’s something that will take several years to roll out and a lot of banks are trying to negotiate with their counterparties and their end clients to be able to move into that regime. Until then, these banks still have to deal with this potential RVA risk. Now let’s go on to the flipside for a second here. We’re really talking in the context of the major dealer and you’ve talked a little bit about those on the other side of the trade of the counter party.
We’re also going to start running into the same problem that we’ve seen in the CDS market right? So you have very liquid names. Highly rated entities, but there’s on the other side of the trade. There aren’t a lot of public credit ratings for smaller type firms. Where there are bonds, for credit dispense they’re not actively traded. So, we’re in interpolation of a probability of default. How is that going to get managed and looked at or is that going to be managed through traditional CVA type charges, or DVA type replacements? I think you’re going back to really around the counter party credit risk of the corporate clients, the pension clients. Where you don’t have a lot of public information around their bond spreads or their – there’s no traded CDS on their name. In most cases, banks will have their internal rating models. Where they actually map either proxy indexes for credits. They’ll have their actually own rating models that determine default probabilities for those corporate issuers.
So last question. So the spaghetti bowl of acronyms is getting bigger and bigger and bigger. Who should be worried about RVA? Who is the practitioner in the bank that should be reading this article today and be adjusting this into their thought process? Well this is fundamentally a pricing issue. So the front office team that’s valuing the trades, managing and entering into these types of trades, they will be the ones that have to deal with most of the headache around these valuation adjustments. The middle office, risk side, is starting to get their hands around and heads around what all the different “XVA” charges are. That’s plenty of work to deal with before even trying to measure and monitor the RVA.