Major dealers are split virtually fifty-fifty on whether to incorporate funding valuation adjustments (FVA) into their accounts at present. Pinpointing evidence of FVA’s existence in swaps prices remains the biggest stumbling block to building consensus – even senior executives within individual firms remaining at loggerheads over this fundamental issue.
But this debate is no longer confined to academic circles and bank treasury desks following banks’ 2013 financial results. While a handful of firms adopted FVA at this time, it was the detailed public announcement from JP Morgan of a US$1.5bn loss that brought the issue into the mainstream and may well force other banks to follow suit.
“Up until two years ago there was a reasonable academic debate, but now people are clear there’s a funding cost in uncollateralised derivatives. The ability for banks to avoid this situation is diminishing. FVA is becoming the standard,” said Simon Wilson, head of counterparty exposure management at RBS.
The UK bank was among the first to report FVA of £475m at the end of 2012. Other notable adherents include Goldman Sachs, Lloyds, Nomura, Deutsche Bank and Barclays. JP Morgan’s move was unique for two reasons: a lengthy explanation of its FVA framework and the size of the loss. DB, which is thought to have comparably-sized derivatives books, recorded a far smaller FVA loss of €276m, while Barclays’ FVA numbers for the end of 2012 and 2013 were £101m and £67m, respectively.
These discrepancies aside, the momentum behind FVA is undoubtedly growing and appears to be outweighing arguments from respected academics such as John Hull that it should not be included in pricing.
“It’s very difficult to clearly observe a price for funding in the market, but that doesn’t mean it’s not there. We look at what we’re executing, but currently we don’t feel there is enough evidence to deduce who is pricing what,” said a European head of counterparty risk management, who indicated it was only a matter of time before his bank adopted FVA.
Show me the money
Banks have pored over thousands of derivatives trades from competitors to divine whether funding was being factored into swaps, but this is easier said than done. In the pre-crisis era, all derivatives were valued using Libor – the supposed risk-free rate at which banks could fund these positions.
Since then, the market has evolved. Collateralised derivatives are funded and, therefore, valued using the margin backing the trade, whether it is cash collateral or government bonds.
Trades with corporates and public sector clients are a trickier valuation prospect, as these counterparties don’t tend to post collateral. This creates a funding need for the bank when it is owed money on the uncollateralised client leg of the trade and has to post collateral against its offsetting hedge in the interdealer market.
This funding cost (or FVA) is factored into the swaps price along with other risk metrics such as the likelihood of the corporate defaulting before the end of the trade (CVA) and the bank’s own credit risk (DVA).
Disentangling all these moving parts has proved a Herculean task for banks, but there are signs of progress. A survey Markit conducted in December known as Totem – where dealers were asked to price a variety of swaps – was reportedly enough to sway the balance in favour of FVA for JP Morgan’s auditors.
Others remain unconvinced, though. Even the major accountancy firms don’t yet feel confident enough to insist on FVA either way: Deloitte, EY and PwC all audit firms sitting in both camps.
“There are strong arguments in favour of FVA, but also some arguments remaining against, along with clear diversity in practice across the market and unresolved debates on methodology. This is a difficult judgmental area, complex to implement, and market consensus is a key driver for banks in deciding how to model their books” said David Todd, partner at KPMG.
Building the new Libor
There remains a startling lack of consistency even between firms that have adopted FVA, as shown by the wildly diverging numbers they have all reported. These discrepancies can be partly explained away: smaller and less directional derivatives books should attract smaller losses when switching to FVA. From an accounting standpoint, there is also a potential overlap between FVA and DVA. Firms that combine the two (as JP Morgan is understood to have done) should report larger FVA numbers than those that keep them separate.
But this hasn’t prevented allegations of banks fudging FVA losses by using overly-optimistic internal funding rates. Rather than using the bank’s own cost of funds, the majority of practitioners argue FVA should be benchmarked against a blended bank funding rate – in effect the new Libor – where banks can actually exit swaps positions. No firm has revealed what funding rate it uses, although JP Morgan cited Libor plus 50bp in a generic FVA example.
“Developing a market standard funding rate is a genuine challenge, but we should see a convergence between banks’ rates. The market needs to have a debate over what is the new Libor,” said Colin Martin, partner at KPMG.
In reality, this debate will play out over many years. The re-pricing of collateralised derivatives was effectively forced on the market by LCH.Clearnet, the clearing house, overhauling its valuation metrics. The debate over funding will likely resemble the move towards CVA, which banks have gradually incorporated into swaps prices over the past 12 years using their own models.
In any case, the shift towards FVA looks unstoppable now, according to Satyam Kancharla, chief strategy officer at Numerix, a risk management software provider. “These are real costs for the bank and that’s why the market is converging towards accepting FVA as the norm,” he said.