Valuations diverge

There is no longer a market standard for pricing unsecured derivatives trades, with valuations for identical instruments likely to vary drastically between banks depending on their own cost of funding, senior traders have admitted.

“On the collateralised side, we all know OIS [overnight indexed swap] is the discount curve. The problem is there is no clear benchmark to reference for uncollateralised trades,” said Christophe Coutte, co-global head of flow, fixed income and currencies at SG. 

“You go from a product where there is a mark to market – the market being the consensus of the Street – to a mark to model, where you won’t have the same value of the same instrument as someone that is facing you.”

Unsecured trades now present a serious valuation headache, traders said. In particular, the need for dealers to incorporate their own charges for funding, credit value adjustment and regulatory capital under Basel III have muddied the waters significantly when it comes to valuing even the most vanilla interest rate swaps.

This contrasts starkly with secured trades, where market consensus has designated OIS as a valuation benchmark (see “Integrating OIS discounting presents challenges”, IFR 1888).

“When pricing an unsecured trade it becomes difficult to determine at which rate you should discount, but also what you should charge for capital, for CVA, should you give them the benefit of any kind of debit value adjustment, and what should you charge for funding. If both counterparties fund at 180bp over Libor, what does that mean for the price?” said Simon Wilson deputy head of delta flow trading at RBS.

Although approaches to CVA and capital charges do vary between banks, dealers estimate their impact on valuation should be muted, unless charges are omitted altogether. However, the gulf between where a thinly-capitalised investment bank funds compared with a bank with a large retail base could lead to a wildly different funding charge, and therefore valuation, for the same trade.

“There is a big discrepancy between where major banks fund themselves, and I do think that has an impact on price and valuation. I remember several occasions when we varied in pricings noticeably with our competitors because of funding,” said one senior trader.

Basel III requires banks to make liquidity provisions for all unfunded instruments. Unsecured derivatives are one of the biggest candidates, according to Coutte at SG, who added: “Ultimately, it’s about what is the right price for the liquidity of this non-funded instrument – a question everyone is trying to answer right now.”

Moreover, bank funding costs have diverged hugely over the past few years. For example, credit protection – a proxy for bank funding – is twice as expensive for Morgan Stanley as it is for HSBC.

Traders say that banks with higher costs of funds will offer attractive prices for clients that are paying fixed – and therefore lending the bank money over the course of the trade – but will be less competitive on deals where they lend the client money.

One head of euro swaps admitted that his bank had looked to take advantage of this dynamic wherever possible, although doing this with legacy positions is challenging because unsecured trades aren’t freely unwound or re-assigned.

“There will be some opportunities,” added Elie el Hayek, global head of rates at HSBC. “If a corporate is paying fixed and wants to assign this trade to a bank with a worse rating, that bank will be willing to pay more for this trade as they are getting in the money. It’s a two-way street, though: worse-rated banks will be more aggressive to get funding, but less aggressive to provide funding.”

Dealers were tight-lipped about the exact process for valuing unsecured trades, although broadly speaking it appeared that many use OIS as a discounting benchmark, and then add provisions for funding, capital and counterparty credit on top.

“If you do something that is too complex for something that is meant to be a vanilla product, then it is not a vanilla product any more, it starts to be an exotic product,” said Coutte. “Does this mean all collateralised business is vanilla and you price non-CSA business off the exotic desk? In the end, we’ve tried to go for something simpler. Using OIS as a reference point and then adding liquidity spreads would make sense.”

However, defining the true cost of funding is very difficult, according to Fleur Meijs, a partner at PricewaterhouseCoopers. For an unsecured trade that is held by a bank to maturity, the economic value of funding the asset should be directly linked to the bank’s own cost of funds. But from an accounting perspective, the fair value of that trade is determined by the exit price, which may vary depending on the funding spreads of the bank that buys the trade.

“It is not clear whether you should value using your own funding cost or whether you need to look at the average funding cost for a basket of banks,” added Meijs. “Economically you might incur your own funding cost, but it might not be what you realise when you sell out of that position – that’s the difficulty.”

Banks will continue to wrestle with unsecured valuations going forward. However, many claimed to have simplified the issue for day-to-day traders by establishing central funding desks – sometimes combined with the CVA desk – to deal with the funding issue.

“We always make adjustments to get to the right price, but we like to centralise all of the exotic risk on our CVA desk and deal with it there. That way our traders can trade the vanilla product they know rather than worry about the underlying complexities that come with unsecured trades,” said Wilson at RBS.