Valuation of derivatives has never been easier but since GFC the complexity in valuing derivatives has gone up multi-folds with the requirement of multi-curve pricing and addition of several adjustments to the price, now commonly known as XVA which refers to CVA, DVA, FVA, KVA and now MVA. MVA, Margin Valuation Adjustment, arise to compensate for the funding cost of the initial margin posted for a transaction. MVA is expected to impact all the uncleared bilateral transactions which will be subject to new initial margining rules applicable to counterparties in next four years depending upon the notional volume of the derivatives transacted by them.
Initial Margin & Variation Margin
Initial margin (IM) is a collateral collected to cover the potential future exposure that could arise from future changes in the market value of a derivative over the close out period in the event of a default by the counterparties where as Variation margin (VM) is a collateral to reflect the current mark-to-market exposure resulting from changes in the market value of a derivative.
New rules require counterparties to post both IM and VM on transactions but there are two key differences which make initial margining rules for banks significant undertaking.
- VM is to be posted on a one-way basis i.e. in favour of a counterparty who has a positive MtM for a netting set where as IM is posted on two-way basis i.e. by both the counterparties on a gross basis which can not be netted;
- VM can be rehypothecated where as IM can not. Rules specifically do not allow IM to be rehypothecated or re-pledged or reused so that collateral is immediately available in the event of a default. This means that this collateral (IM) do not earn any income from the third party custodian with whom it is held in the segregated account. This is the aspect that adds to the cost of funding the collateral.
Impact of New IM Rules
Since initial margin is to be posted on a gross basis, the total IM requirement and related costs could be potentially significant for banks. Though there are some estimates available on the cost of funding IM for the banking industry, I have estimated this cost for one of the Australian banks. Based on the notional amounts provided in the bank’s 2015 annual report and certain simple assumptions, I estimate the IM requirement for the bank to be in the range of A$3 – A$7.5 billion. Assuming that the cost of funding this IM is 80bps, it will take away approximately A$24 – $60 million from the bank’s bottomline if this cost is not passed on to the customers or managed properly. It is expected that reduction in Counterparty Credit Risk and CVA capital charge due to IM potentially helping to reduce default risk should compensate for some of the IM funding costs.
Picture below shows schedule based IM estimates under two scenarios – one when NGR (Net to Gross Ratio) =1 i.e. no netting benefit is available in the portfolio and second when NGR = 0 i.e. when net MtM of the complete portfolio is zero but the maximum benefit available is only 60%.
Key assumptions made in the above analysis are:-
- One netting set;
- 90% of interest rate swaps can be cleared;
- Uniformly distributed expected maturity of transactions;
- Zero Threshold and Zero Minimum Transfer Amount;
- No perfectly offsetting transactions which can be netted to reduce the notional.
For more information on these estimates, please leave a comment to this post or e-mail me at [email protected]
Margin Valuation Adjustment
Margin Valuation Adjustment (MVA) is actually a funding cost of the initial margin. In that sense it is same as FVA for VM and can also be called as FVA for IM. Picture below provides a comparison of existing margining rules when a bank transacts with a customer (uncollateralised and collateralised) and then hedges the market risk with the collateralised counterparty, typically another financial institution. To keep things simple, I have assumed symmetric two way CSA’s where counterparties are collateralised.
It can be seen that new initial margining rules will be introducing additional adjustments to compensate for the cost of funds required for funding initial margin.
- Computational Complexity – Clearly first item is to model MVA which will be a complex process. Ideally a Monte Carlo simulation will be required to calculate the IM in each time step and scenario which will have to be multiplied by the funding spread and then present valued. This is a case of the Monte Carlo within another Monte Carlo as IM calculation itself requires a MC simulation where a schedule based approach or ISDA’s Standard Initial Margin Model (SIMM) is not used.
- Transaction Pricing – Given the computational complexity, banks will have to deploy systems and processes to generate marginal MVA on the fly to be included in the pricing.
- Collateral Management – Banks will have to manage collateral optimally taking into account constraints imposed by LCR and NSFR as well as prescribed eligible collateral requirements as per IM rules.
- Documentation – Due to staggered timeline to implement new margining rules for uncleared derivatives, banks may have to maintain multiple ISDAs (and CSAs) until all the banks/customers are on the same documentation. This means that there will be some netting sets which will be subject to MVA but others not during this duration.
- Cross-Border Implementation Variations – Whilst principles based on which margin requirements for uncleared derivatives are drafted will be largely consistent across jurisdictions, there will be some subtle differences and very likely different timelines. Such differences may result in arbitrage opportunities for banks during the implementation phase.
- Dispute Resolution – Where banks decide to use non-standard internal model for calculating IM, mechanism will be required to resolve initial margin related disputes.
Though MVA is relatively a new term used in the industry, it in reality refers only to the FVA for IM. Having said that there is a significant complexity in modelling MVA and then including this funding cost in every day pricing. We noted above the likely impact on one bank’s funding requirement. In my opinion this funding cost is likely to be even larger if NSFR requirements are taken into account as that would force banks to fund IM with “more stable funding”. In addition to this, there are a number of operational issues to be addressed while implementing new margining rules.