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XVA explained
Valuation adjustments and their impact
on the banking sector
December 2015
XVA explained
Introduction Background
The past decade has seen a raft of The global financial crisis saw a As derivative desks have traditionally
changes in the banking industry, with structural shift in the operation relied upon cheap, unsecured borrowing
a focus on seemingly never-ending of the global banking sector. Two to fund their operations, this change has
new regulation. changes are particularly relevant in significantly increased the funding costs
One of the less well understood understanding XVA. for banks actively trading derivatives. We
changes is a revision to the The first relates to the operation of have set out below a simplified illustration
fundamentals of trading book fair the interbank funding market. During to highlight the differences that flowed
value measurement and pricing, the crisis, and especially post the from these changes, and how they are
through the gradual introduction of Lehman collapse, concerns about impacting core inputs to derivative pricing
various valuation adjustments. These bank creditworthiness led to an almost and valuation concepts seen today.
are far from minor tweaks to banks’ complete breakdown of the interbank
balance sheets; instead they are funding market. Post the crisis, interbank
having a genuine impact on earnings lending rates have been more volatile
across the industry. and traded at increased spreads to the
For example, one major global Central Bank rate. This has reflected
investment bank reported a loss of a correction in the market view of
$1.5Bn due to ‘Funding Valuation bank credit risk.
Adjustments’. Also known as FVA,
this has joined CVA and DVA in the Changes in inter-bank funding
apparently ever-expanding list of
adjustments to derivative contract
valuations. What are these adjustments
and where do they come from?
In this article we describe the origins of
FVA and the many related adjustments
which go under the umbrella name Cost of funding
of ‘XVA’. We then discuss how XVA
affects auditors and, finally, we will
look at how these are driving change in B
banks’ front office teams. LIBOR/BBSW
A
OIS

2004 2006 2008 2010 2012 2014

A: Post GFC, there is a greater divergence between benchmark rates that were traditionally regarded as
‘risk free’ (such as BBSW and LIBOR) and the Overnight Index Swap (OIS) rate, where the OIS rate is
now seen as a better proxy of the ‘risk free’ rate.
B: Banks’ funding costs over and above LIBOR have increased post GFC as the market repriced
bank credit risk.

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The second significant change has been
A ‘fully-costed’derivative
the introduction of new regulation to
ensure that the banks are adequately Adjustment Description Applicable to
capitalised. These have targeted OTC
Primarily uncollateralised derivative
derivative transactions, and have had CVA (2002+) Impact of counterparty credit risk.
assets.
such an impact that trading desks have
Benefit a bank derives in the event of its Primarily uncollateralised derivative
needed to incorporate these changes in DVA (2002+)
own default (the ‘other side’ of CVA). liabilities.
pricing. Further new regulation will require Captures the funding cost of
all financial sector derivatives that are not FVA (2011+) uncollateralised derivatives above the Uncollateralised derivatives.
cleared through central clearinghouses ‘risk free rate’.
to be collateralised (margined), in much Cost of funding a collateralised derivative
OIS/COLVA (2010+) Collateralised derivatives.
the same way as exchange traded position, at new ‘risk free’ rate.
instruments or futures contracts. The Cost of holding regulatory capital as a All derivative contracts, more punitive
KVA (2015+)
costs of margining, and associated result of the derivative position. on trades that are not cleared.
liquidity volatility, represents further
overhead in trading derivatives.
As a result of the above macro changes,
we have seen the introduction of various
derivative valuation adjustments,
essentially to reflect the additional Cost of posting ‘initial margin’ against a Derivatives that are cleared, likely
MVA (2015+)
derivative position. wider population in the future.
‘costs’ in holding derivative contracts
today. From an accounting perspective,
in concept this is similar to an inventory Credit Valuation Adjustment (CVA)
costing model, where additional costs are
being factored into unit pricing and, for
CVA is probably the most widely known • a loan contract typically has standard
and best understood of the XVA. CVA and predictable future cashflows,
existing ‘stock’, valuation.
captures the ‘discount’ to the standard and therefore an easily calculated
Some of these adjustments, like Credit derivative value that a buyer would offer ‘credit exposure’. Derivative cashflows
Valuation Adjustments (CVA), are well given the risk of counterparty default. are highly variable and difficult to
understood and already an integral part In concept, it is somewhat akin to predict. As such, sophisticated CVA
of the way that banks price derivatives. credit provisions on loan assets. There calculations involve Monte Carlo
Others are emerging, and many banks are are two key differences to loan loss approaches to determine the range
unable to reliably quantify and compute provisions though: possible future exposures.
the adjustments.
• derivatives are marked to market, Currently, the industry is revisiting
A key challenge is that a number of these requiring a ‘market price’ to accept the blanket use of CDS rates in CVA
adjustments need to be calculated on a the risk of counterparty default. This calculations. This is due to reduced
portfolio basis, not trade by trade. This is often calculated by reference to the liquidity in CDS contracts, flowing
has led to changes in bank structures. cost of hedging the counterparty credit from lower participation by banking
The required changes in IT infrastructure, risk on the contract, through credit intermediaries reacting to banking
organisational reporting lines and front default swaps (CDS); regulation such as the Volcker rule.
office staffing are proving costly, ironically
adding further costs to trading functions.

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Debit Valuation Adjustment (DVA)
DVA is a rather counter intuitive notion as the market value of the derivative, the
it involves recording a gain as the bank’s remainder being a windfall to the bank’s
own credit risk deteriorates. bondholders. This windfall benefit is
Consider the situation where a bank captured in DVA.
trades an uncollateralised OTC derivative. DVA is normally computed in much the
Assume now that the bank defaults same way as CVA, and is often thought
when the derivative is ‘out of the money’. of as ‘the other side’ of CVA (ie. a bank’s
The counterparty to the derivative DVA is its counterparty’s CVA).
typically recovers only a proportion of

Funding Valuation Adjustment (FVA)

Standard derivative valuation models be used to fund other ventures, in lieu of
used in most banking and corporate raising external funding. The value of the
treasury systems assume a discount funding benefit can be seen as the rate at
rate based on benchmark rate (LIBOR which the bank can raise cash, which is
or BBSW). These models therefore based on its credit quality. FBA therefore
assume the time value of money, or has significant overlap with DVA.
funding rate available to the bank, is the Similarly, a funding cost arises for the
benchmark rate. As outlined at the onset bank when a derivative has a positive
of this paper, post-GFC there has been market value. The purchase of an ‘in
a significant divergence in the cost of the money’ or asset position derivative
funding available to a bank versus the requires the bank to pay cash. The
benchmark rate. FVA attempts to capture incremental cost of funding this purchase
the cost of funding uncollateralised can also be seen as equivalent to the
OTC derivatives. FVA is divided into two cost of the bank raising funding. FCA is
component adjustments, being: also therefore a function of the bank’s
• Funding Benefit Adjustment (FBA), and credit quality, and is calculated typically
• Funding Cost Adjustment (FCA). using the same rate as FBA.
A funding benefit arises for the bank Note that unlike the FBA/DVA overlap,
typically when the derivative has a FCA is more distinct from CVA, as FCA
negative market value (liability). Consider is based on the bank’s own funding
the case where a bank acquires a cost (and credit quality), whereas CVA
derivative in a liability position. The bank is based on the credit quality of the
will accept this liability in exchange for bank’s counterparty.
cash. The cash received by the bank can

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Collateral Valuation Adjustment (COLVA or OIS)
Posting collateral (margin) against a such, receiving collateral on a derivative
derivative position significantly alters reduces the need to otherwise fund that
both the credit risk and funding profile position at a more expensive rate. The
of that position. converse holds true for positions that are
A perfectly collateralised derivative has out of the money. COLVA or OIS captures
no credit risk, and therefore requires no this cost or benefit.
CVA (or DVA). In practice though, these There are several complications in the
situations are rare due to operational calculation of OIS, given the range of
practicallities in posting collateral, so collateral that can be posted under
credit risk is rarely completely eliminated. existing contracts (ranging in cash
The collateral received against an in-the- in different currencies to different
money trade typically means the receiving securities). Some banks have developed
bank pays interest at the overnight sophisticated tools to ensure they are
cash funding rate (approximated by the posting the ‘cheapest to deliver’ collateral
Overnight Index Swap, or OIS, rate). As given the range of options.

Capital Valuation Adjustment (KVA)

Banks are required to hold capital Consistency of KVA across the industry
reserves in order to survive large is difficult as some banks have standard
unexpected credit, market or operational capital models, whereas others use
risk losses. The introduction of Basel advanced methods. In addition, some
III, following the GFC, has substantially banks are forward thinking in pricing,
increased the capital required by banks and starting to factor in future regulatory
for holding derivative contracts. KVA capital changes such as those contained
captures the cost of this additional in the Fundamental Review of the Trading
regulatory capital. Book (FRTB). This is essentially to protect
KVA is having a substantial impact on the the bank today from writing a long-dated
way traders’ price derivatives, as capital (eg. 20 year) derivative contract that will
charges do not ‘disappear’ when market be punitive under the regulatory capital
risk is offset in the trading book. Consider regime of tomorrow.
for example a portfolio consisting of At this point in time, there are virtually no
a derivative and a perfectly offsetting banks that have adopted KVA for books
hedge contract. Both the derivative and records due to ongoing debates on
and the hedge will likely generate KVA methodology. We expect this to change
individually, whereas traditionally this as industry consensus develops.
would be seen as a ‘zero risk’ position.

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Margin Valuation Adjustment (MVA)
New regulations aim to enforce both Initial margin requirements vary during
initial and variation margin postings on all the life of the trade and are typically
derivative transactions between financial computed based on a Value at Risk (VAR)
institutions that are not cleared through a type approach. Initial margin is already
central clearinghouse by 2019. being posted on the rapidly growing
Variation margin represents the day- set of derivative contracts that are
to-day fluctuation in mark to market being posted at clearinghouses. Whilst
positions and is much the same as the MVA approaches and methodology are
collateral agreements covered by the being discussed at an industry level,
COLVA or OIS adjustment. Initial margin banks are yet to adopt MVA against
is different to variation in two respects: derivative positions in their accounting
books and records.
• Whilst variation margin can be thought
of as symmetrical – you post collateral
if out of the money and you receive
if in the money – Initial Margin is a
‘sunk cost’ on each contract;
• Initial margin is generally not
re-hypothecable.

The auditor’s perspective

The reporting of valuation adjustments On the other hand, accountants
in financial statements has been a topic recognise that doing nothing is not an
of considerable debate in the finance option. The developments noted in this
and audit community over the past paper highlight a number of risks that
decade. The financial crisis further are not being captured in the traditional
focused minds, particularly in the case practice of booking mark-to-market ‘Day
of counterparty credit adjustments. 1’ profits on derivative transactions,
However, market consensus has been derived using standard market inputs.
slow to solidify and as a result views This is particularly in recognition of
on the accounting treatment of some trading positions that can sit on a bank’s
valuation adjustments remain in flux. books for 10 or 20 years.
It has certainly become the norm to From an accounting standards
recognise both CVA and DVA in the perspective, IFRS 13 and ASU 2011-04
accounts for large financial institutions, were issued in May 2011 and resulted
however, the inclusion of DVA left many in substantially converged fair value
people uncomfortable. Other concerns measurement and disclosure guidance
with XVA include the potential for ‘double between U.S. GAAP and IFRS. There are
counting’ with DVA, CVA and FVA. With still certain key differences between the
FVA in particular, the debate continues fair value measurement and disclosure
on how to reconcile an entity’s own guidance under the two standards.
funding costs to the accounting view of However, as far as we are aware there
fair value, which requires an ‘exit price’ are no differences that would result in a
or market price. difference in measurement of XVAs.

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During the 2014 financial year we market participant would pay (or receive)
have witnessed most bulge bracket to assume your derivative contract?
investment banks report FVA in their It is clear that banking market
annual accounts for the first time. This participants today will offer a ‘discount’
was closely followed by Canadian off the price calculated by standard
banks, and then replicated in Australia. valuation models to account for funding
This is a significant step forward as we costs, credit risk and regulatory capital.
close in to a consensus, at least in the The mix between these components from
banking industry. an accounting perspective is, in our view,
Outside of the banking sector, there is arbitrary. As an example, one bank can
still significant deliberation on XVAs. A adjust the price of a $100 contract by $3
point of differentiation is non-banking for FVA, $2 for CVA and $1 for MVA, with
entities are unlikely to have access to a total value of $94. Another can apply
the inter-dealer market. Under IFRS its methodology to the same contract
13, this means that such entities would to calculate $1 for FVA, $3 for CVA
mark derivative products to the most and $2 for MVA.
advantageous price available to them, As long as the ultimate contract price
which could be different to that available is supportable by reference to traded
to the major banks. market prices, we see differences in
Regardless of industry, in our view the methodology for component calculations
key question that we should not lose as less relevant.
sight of is – what is the price another

XVA – the challenges to come

Valuation adjustments have been a hot At an operational level at banks, the
topic for a number of years now. In this challenges of XVA are deeper. XVA
article we have considered the primary implementation is requiring an operating
sources of valuation adjustment and model change to traditional front office
described how they arise. trading operations, and significant
At face value, the net impact of XVAs is investment in IT infrastructure is required
that there is dispersion in both valuation to assist Finance, Risk and Operations
and pricing on previously ‘vanilla’ functions with the change.
derivative contracts. Whilst we expect
this to converge going forward, the
experience with XVA to date suggests
this can have a longer lead time than one
would initially expect.

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The authors
This paper is based on source material originally produced by Rob Bozeat,
Richard Hubbard & George Theophylactou, PwC UK and tailored for the
Australian market context.

Yura Mahindroo
Partner – PwC Australia
[email protected]

Ewan Barron
Partner – PwC Australia
[email protected]

Michael Codling
Partner – PwC Australia
[email protected]

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