“In the old days, there was complexity on products with leverage and pay-off. Now, the derivatives are simple – the complexity is in the accounting. The world has been turned upside down.” Head of markets at a major dealer.
The financial crisis has transformed the derivatives business which is now relatively less about value-pricing a differentiated product (with a complex payoff, presented as a “customized risk solution”, but also tending to obfuscate fair-value) and more about cost-advantage in commoditized product.
- In addition to dependence on the credit spreads of reporting dealer and counterparty (given, post-crisis, the decisive industry move away from default-free pricing), the relevant costs are increasingly driven by portfolio effects and particularly the relevant “netting set” as defined by regulators and clearing houses. Indeed, dealers now explain uncompetitive pricing to clients in terms of being “wrong way round” at the clearing house (meaning that a given trade adds to, rather than nets against, credit and/or funding costs).
Investors understand the impact on trade profitability of capital charges, but valuation adjustments can have a greater impact. For example, pioneering analytics provider, Quantifi, estimates the all-in cost of these adjustments at 3 basis points for an at-the-money (ATM) 10-year received-fixed swap versus less than ½ basis point for the cost of capital charges (assuming these are debt-, rather than equity-, funded); in comparison, the bid-ask spread is less than ¼ basis point.
- As shown in the Exhibit below, the relative impact of valuation adjustments is also high for in-the-money (ITM) and out-of-the-money (OTM) swaps as well as for a stressed-, rather than only base-case market-, volatility scenario.
An increasingly important element of these valuation adjustments, currently accounting for 20-25% of the total, is due to funding; specifically, a funding valuation adjustment or FVA reflects the present-value of expected funding costs for a derivatives-related obligation to post collateral. In 2014Q1, JPM commented that “for the first time, we were able to clearly observe the existing of funding costs in market clearing levels”, and the impact is likely to increase with inter-dealer collateral requirements (as the industry shifts to central-clearing and extends the collateral requirements of central-clearing to bilateral trades) and as rates normalize.
- For example, Deloitte estimates that the cost of posting T-bills or agency securities as collateral will double with an increase in the effective fed funds rate from 0.1% today to 2%.
Mitigating this increase in the funding costs of collateral will be important to competitive advantage, and requires enterprise-wide technology to link front-office pricing to optimal choices in the middle- and back-offices for both clearing venue (and trading venue when clearing is not “open” because of vertical integration with trading) and cheapest-to-deliver collateral (across repo, OTC derivatives, and listed derivatives businesses, for example). We see GS as the leader in this enterprise-wide risk-management technology, and associated pricing-support tools for traders.
- In May, for example, President & COO Gary Cohn commented: “We made a decision to have a single unified risk management system for all of Goldman Sachs. We have one risk management system that everything in the world goes in that calculates every potential cost, and shows every trader every possible outcome, every possible way to hedge that can go on. And they can literally manipulate anything they want within the system. It’s got an enormous amount of data”.
 There is a case for using the shadow cost of capital which would be higher than the own credit spread at 0.5% and as high as the target ROE (i.e. at least 10%) for firms with tight capital constraints.
 Of course, there is no FVA in the pre-crisis environment when derivatives cash flows are discounted as the same rate assumed for dealer funding costs. Now, however, dealer funding-rates are not assumed to be risk-neutral so that an FVA arises when there is a collateral mismatch and the dealer needs to borrow to fund the difference as can occur when the original trade is with a collateral exempt end-user but the hedge, as is typical, is with another dealer and increasingly centrally-cleared. In this instance, when the original trade is in-the-money, the hedge has negative present value creating a collateral requirement in the inter-dealer market particularly in a centrally-cleared environment; this collateral is not funded by the original (uncollateralized) trade, so that the reporting dealer needs to borrow in the open market.
Please see our published research for the full note and tables.