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there has been a significant “too big to fail” problem in that the biggest banks and financial firms could not be allowed to fail and therefore should be subject to even tighter risk controls and oversight. It was therefore obvious that there would need to be a massive shift in the regulatory oversight of banks and large financial firms. Rules clearly needed to be improved, and new ones introduced, to prevent a repeat of the global financial crisis.

      It is not, therefore, surprising that new regulation started to emerge very quickly with the Dodd–Frank Act, for example, being signed into law in July 2010, and totalling almost one thousand pages of rules governing financial institutions. In addition, Basel III guidelines for regulatory capital have been developed and implemented relatively rapidly (compared with, for example, the previous Basel II framework). Much of the regulation is aimed squarely at the over-the-counter (OTC) derivatives market where aspects such as counterparty risk and liquidity risk were shown to be so significant in the global financial crisis.

      This pace and range of new regulation has been quite dramatic. Additional capital charges, a central clearing mandate and bilateral rules for posting of collateral have all been aimed at counterparty risk reduction and control. The liquidity coverage ratio and net stable funding ratio have taken aim more at liquidity risks. A leverage ratio has been introduced to restrict a bank’s overall leverage. An idea of the proliferation of new regulation in OTC derivatives can be seen by the fact that the central clearing mandate led to new capital requirements for exposure to central counterparties which in turn (partially) required a new bilateral capital methodology (the so-called SA-CCR discussed in Chapter 8) to be developed. Not surprisingly, there are also initiatives aimed at rationalising the complex regulatory landscape such as the fundamental review of the trading book. For a typical bank, even keeping up with regulatory change and the underlying requirements is challenging, let alone actually trying to adapt their business model to continue to be viable under such a new regulatory regime.

      At the same time as the regulatory change, banks have undertaken a dramatic reappraisal of the assumptions they make when pricing, valuing and managing OTC derivatives. Whilst counterparty risk has always been a consideration, its importance has grown, which is seen via significant credit value adjustment (CVA) values reported in bank’s financial statements. Banks have also realised the significant impact that funding costs, collateral effects and capital charges have on valuation. Under accounting rules, CVA was subject to a very strange marriage to DVA (debt value adjustment). Nonetheless, this marriage has produced many offspring such as FVA (funding value adjustment), ColVA (collateral value adjustment), KVA (capital value adjustment) and MVA (margin value adjustment). OTC derivatives valuation is now critically dependent on those terms, now generally referred to as xVA.

      It is important not to focus only on the activities of banks but also to consider the end-users who use OTC derivatives for hedging the economic risks that they face. Whilst such entities did not cause or catalyse the global financial crisis, they have been on the wrong end of increasing charges via xVA, partially driven by the regulation aimed at the banks they transact with. The activities of these entities has also changed as they have aimed to understand and optimise the hedging costs they face.

      Hence, there is a need to fully define and discuss the world of xVA, taking into account the nature of the underlying market dynamics and new regulatory environment. This is the aim of this book. In Chapters 2–4 we will discuss the global financial crisis, OTC derivatives market and birth of xVA in more detail. Chapters 5–9 will cover methods for mitigating counterparty risk and underlying regulatory requirements. Chapters 10–12 will discuss the quantification of key components such as exposure, default probability and funding costs. Chapters 13–16 will discuss the different xVA terms and give examples of their impact. Finally, in Chapters 17–20 we will discuss the management of xVA at a holistic level and look at possible future trends.

      2

      The Global Financial Crisis

      Life is like playing a violin solo in public and learning the instrument as one goes on.

Samuel Butler (1835–1902)

      2.1 Pre-crisis

      Counterparty risk first gained prominence in the late 1990s when the Asian crisis (1997) and default of Russia (1998) highlighted some of the potential problems of major defaults in relation to derivatives contracts. However, it was the failure of Long-Term Capital Management (LTCM) (1998) that had the most significant impact. LTCM was a hedge fund founded by colleagues from Salomon Brothers’ famous bond arbitrage desk, together with two Nobel Prize winners Robert Merton and Myron Scholes. LTCM made stellar profits for several years and then became insolvent in 1998. LTCM was a very significant counterparty for all the large banks and the fear of a chain reaction driven by counterparty risk led the Federal Reserve Bank of New York to organise a bailout whereby a consortium of 14 banks essentially took over LTCM. This failure was a lesson on the perils of derivatives; LTCM has been running at a very significant leverage, much of which was achieved using OTC derivatives together with aspects such as favourable collateral terms. This in turn exposed banks to counterparty risk and raised the prospect of a knock-on impact, causing a cascade of defaults. It was the possibility of this chain reaction that led to the rescue of LTCM because of a perceived threat to the entire financial system.

      One of the responses to the above was the Counterparty Risk Management Policy Group (CRMPG) report in June 1999. CRMPG is a group of 12 major international banks with the objective of promoting strong counterparty credit risk and market risk management. Further major defaults such as Enron (2001), WorldCom (2002) and Parmalat (2003) were not as significant as LTCM, but provided a continued lesson on the dangers of counterparty risk. Many banks (typically the largest) devoted significant time and resources into quantifying and managing this. The CRMPG issued a report in January 2005, stating that:

      Credit risk, and in particular counterparty credit risk, is probably the single most important variable in determining whether and with what speed financial disturbances become financial shocks with potential systemic traits.

      Meanwhile, efforts to ensure that banks were properly capitalised were being initiated. The Basel Committee on Banking Supervision (BCBS) was established by the Group of Ten (G10) countries in 1974. The Basel Committee does not possess any formal authority and simply formulates broad supervisory standards. However, supervisory authorities in the relevant countries generally follow the BCBS guidelines when they develop their national regulation rules. In 1988, the BCBS introduced a capital measurement framework now known as Basel I that was more or less adopted universally. A more risk-sensitive framework, Basel II, started in 1999. The Basel II framework, now covering the G20 group of countries, is described in the Basel Committee’s document entitled International Convergence of Capital Measurement and Capital Standards (BCBS, 2006). It consists of three “pillars”:

      • Pillar 1, minimum capital requirements. Banks compute regulatory capital charges according to a set of specified rules.

      • Pillar 2, supervisory review. Supervisors evaluate the activities and risk profiles of banks to determine whether they should hold higher levels of capital than the minimum requirements in Pillar 1.

      • Pillar 3, market discipline. This specifies public disclosures that banks must make. They provide greater insight into the adequacy of banks” capitalisation (including disclosure about methods used to determine capital levels required).

      Requirements for counterparty risk capital were introduced in Basel I and were clearly set out under Pillar 1 of Basel II.

      Meanwhile, the growth of the derivatives markets and the default of some significant clients, such as Enron and WorldCom, led banks to better quantify and allocate such losses. Banks started to price in counterparty risk into transactions, generally focusing on the more risky trades and counterparties. Traders and salespeople were charged for this risk, which was often then managed centrally. This was the birth of the CVA desk. Initially, most banks would not actively manage counterparty risk but adopted some sort of income deferral, charging a CVA to the profit of a transaction. Calculations were typically based on historic probabilities of default and the CVA amounted to an expected loss that built up a collective reserve to offset against counterparty defaults. A CVA desk generally acted as an

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