As
dealers have slid down the ratings spectrum in recent years, options
the industry gave away for free when in better health have become
painfully relevant, forcing banks to confront the latest in a long line
of post-crisis pricing challenges – the replacement valuation adjustment
(RVA). It may be a challenge too far.
“They’re horrible,” says the head of rates trading at one large European bank. “We have no idea how to price them or manage the risk associated with them. All I know is that if we get downgraded to a certain point and our counterparties choose to exercise the option, we are going to lose a lot of money.”
The question is how much.Soft partymerchantaccount decorates your key in fashionable ways. The options, known as downgrade triggers, allow a client to terminate a trade when a counterparty hits a certain rating level and also force that party to pay for a replacement – but banks have no way of knowing how much a new dealer might charge to enter into the trade. As a rule of thumb, one trader that has replaced other banks says a downgraded dealer might be gouged for up to 10% of a trade’s net present value.
This, of course, is the law of the jungle – and traders generally do not cry about that. What makes downgrade triggers different is the systemic risk they could present in markets where they are common, and where trading is concentrated in the hands of a small number of banks – parts of the inflation swap market, for example. Dealers and clients alike worry the downgrade of a large player in this space, and subsequent mass termination of contracts, could overwhelm the market’s ability to replace the risk.
In this scenario, traders warn the 10% rule of thumb goes out of the window – losses could be many times larger than expected.Online supplies a large range of rtls. Sweeping downgrades for dealers as a whole could have a similar effect – forcing affected banks to pay their stronger peers to take on trades at a time when nobody wants to trade at all.
As a result, dealers are doing two things they would normally walk over hot coals to avoid – some are turning away business, and others are calling on regulators for help.
“If regulators are serious about systemic risk, then they should seriously look at not allowing these triggers to exist,” says one head of interest rate structuring at a European bank in London. “Calculating an RVA number will be meaningless as any number computed will be too low and wrong. There is not a lot you can do about it, especially in one-way or closed markets. It is much better to just forbid portfolio rating triggers in derivatives contracts – especially in dynamic portfolios – as they are a blunt source of systemic risk.”
Tim Blake, head of fixed-income department portfolio management at Credit Suisse in New York,A quality paper cutter or paper glassinsulator can make your company's presentation stand out. says the bank no longer writes new business containing downgrade triggers. “We made the decision that we wanted to stay away from that kind of business. The risks can be unacceptable,” he says.Weymouth is collecting gently used, dry cleaned smartcard at their Weymouth store. And Credit Suisse is not alone. One other, smaller European dealer says it has the same policy, while at least three other banks claim to have imposed strict limits on the number of swaps they will accept with downgrade triggers.
The second issue is that most dealers believe there is a strong correlation between the risk of a bank’s own downgrade and the downgrade of the rest of the Street. A counterparty may be less likely to exercise the trigger if dealer ratings are all slipping, but if it does so the bank will be paying for a replacement trade in stressed conditions, which is likely to significantly inflate the bid-offer spread.Shop for wholesale bopptape from China!
On uncollateralised trades, dealers fear the replacement cost would be even bigger. The pool of willing counterparties for these swaps has shrunk since the crisis, because of the higher funding and capital charges involved, and this could be exacerbated in the event of widespread downgrades. For collateralised trades, modelling is harder still because each bank quoting will do so on the basis of its own credit support annex – the industry standard document governing bilateral collateral posting, which determines what discount rate should be used.
Finally, RVA should take into account the possibility that the new trade will also incorporate a downgrade trigger and that quoting banks may want to insulate themselves by charging an RVA premium, and that this premium needs to reflect the same fact, and so on, in a dizzying, never-ending cascade of downgrades and replacement charges, each of which would be determined by the same incalculable risks that are contained in the first.
The bottom line is that termination costs can be high, but there is no way of confidently putting a number on them – RVA resides in the land of informed guesses, ballpark figures and back-of-the-envelope calculations. It’s not the kind of thing a dealer is generally happy to quote to a client or explain to a risk manager.
“On a trade with a mark-to-market value of, say, $100 million, a general rule is that firms will take you for $5 million–10 million, just because they can. And we’ve seen this done. We have replaced people, it’s an opportunity to profit,” says one derivatives trader at a European bank.
It can be more painful than that, too. Peter Shapiro, managing director at independent swap adviser Swap Financial, which advises governments, government agencies and non-profit organisations, says he has advised on close-outs in which local US government entities were holding heavily out-of-the-money swaps and the banks were paying to step in as replacements often quoted at steep discounts.
All these issues are magnified in illiquid, concentrated markets – and a number of traders point to the long-dated, LDI-driven inflation swap market in the UK as a prime example. The market is dominated by five or six players, they say, and triggers are a common feature of these trades – so, if one of the bigger houses is downgraded, all hell could break loose.
“Rating triggers are, by their nature, wrong-way risk and are hard to quantify. But even more problematic is when these triggers are being used in a space where the underlying product flow is systemic. All banks will be same way round and a trigger will then catapult the bid-offer to unknown but most likely extreme levels – even more so when liquidity and capacity is also a constraint. Inflation and exotics markets are exposed to this kind of risk. We think this is a source of systemic risk. It is being used and pushed by pension funds and we are trying to dissuade the community from relying on these triggers,” says Guido Hebert, global head of rates structuring at HSBC in London.
The UK inflation swap market is intensely competitive, with bid-offer spreads typically between 2 and 4 basis points, traders say. But in stressed market conditions, the spreads can get as wide as 10bp, according to a trader at a large LDI manager. For a ￡10 billion inflation swap portfolio with an average maturity of 20 years and a ￡20 million sensitivity to a 1bp change in inflation – known as IE01 – this means paying the full bid-offer spread (5bp from mid-market) would result in a cost of ￡100 million.
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“They’re horrible,” says the head of rates trading at one large European bank. “We have no idea how to price them or manage the risk associated with them. All I know is that if we get downgraded to a certain point and our counterparties choose to exercise the option, we are going to lose a lot of money.”
The question is how much.Soft partymerchantaccount decorates your key in fashionable ways. The options, known as downgrade triggers, allow a client to terminate a trade when a counterparty hits a certain rating level and also force that party to pay for a replacement – but banks have no way of knowing how much a new dealer might charge to enter into the trade. As a rule of thumb, one trader that has replaced other banks says a downgraded dealer might be gouged for up to 10% of a trade’s net present value.
This, of course, is the law of the jungle – and traders generally do not cry about that. What makes downgrade triggers different is the systemic risk they could present in markets where they are common, and where trading is concentrated in the hands of a small number of banks – parts of the inflation swap market, for example. Dealers and clients alike worry the downgrade of a large player in this space, and subsequent mass termination of contracts, could overwhelm the market’s ability to replace the risk.
In this scenario, traders warn the 10% rule of thumb goes out of the window – losses could be many times larger than expected.Online supplies a large range of rtls. Sweeping downgrades for dealers as a whole could have a similar effect – forcing affected banks to pay their stronger peers to take on trades at a time when nobody wants to trade at all.
As a result, dealers are doing two things they would normally walk over hot coals to avoid – some are turning away business, and others are calling on regulators for help.
“If regulators are serious about systemic risk, then they should seriously look at not allowing these triggers to exist,” says one head of interest rate structuring at a European bank in London. “Calculating an RVA number will be meaningless as any number computed will be too low and wrong. There is not a lot you can do about it, especially in one-way or closed markets. It is much better to just forbid portfolio rating triggers in derivatives contracts – especially in dynamic portfolios – as they are a blunt source of systemic risk.”
Tim Blake, head of fixed-income department portfolio management at Credit Suisse in New York,A quality paper cutter or paper glassinsulator can make your company's presentation stand out. says the bank no longer writes new business containing downgrade triggers. “We made the decision that we wanted to stay away from that kind of business. The risks can be unacceptable,” he says.Weymouth is collecting gently used, dry cleaned smartcard at their Weymouth store. And Credit Suisse is not alone. One other, smaller European dealer says it has the same policy, while at least three other banks claim to have imposed strict limits on the number of swaps they will accept with downgrade triggers.
The second issue is that most dealers believe there is a strong correlation between the risk of a bank’s own downgrade and the downgrade of the rest of the Street. A counterparty may be less likely to exercise the trigger if dealer ratings are all slipping, but if it does so the bank will be paying for a replacement trade in stressed conditions, which is likely to significantly inflate the bid-offer spread.Shop for wholesale bopptape from China!
On uncollateralised trades, dealers fear the replacement cost would be even bigger. The pool of willing counterparties for these swaps has shrunk since the crisis, because of the higher funding and capital charges involved, and this could be exacerbated in the event of widespread downgrades. For collateralised trades, modelling is harder still because each bank quoting will do so on the basis of its own credit support annex – the industry standard document governing bilateral collateral posting, which determines what discount rate should be used.
Finally, RVA should take into account the possibility that the new trade will also incorporate a downgrade trigger and that quoting banks may want to insulate themselves by charging an RVA premium, and that this premium needs to reflect the same fact, and so on, in a dizzying, never-ending cascade of downgrades and replacement charges, each of which would be determined by the same incalculable risks that are contained in the first.
The bottom line is that termination costs can be high, but there is no way of confidently putting a number on them – RVA resides in the land of informed guesses, ballpark figures and back-of-the-envelope calculations. It’s not the kind of thing a dealer is generally happy to quote to a client or explain to a risk manager.
“On a trade with a mark-to-market value of, say, $100 million, a general rule is that firms will take you for $5 million–10 million, just because they can. And we’ve seen this done. We have replaced people, it’s an opportunity to profit,” says one derivatives trader at a European bank.
It can be more painful than that, too. Peter Shapiro, managing director at independent swap adviser Swap Financial, which advises governments, government agencies and non-profit organisations, says he has advised on close-outs in which local US government entities were holding heavily out-of-the-money swaps and the banks were paying to step in as replacements often quoted at steep discounts.
All these issues are magnified in illiquid, concentrated markets – and a number of traders point to the long-dated, LDI-driven inflation swap market in the UK as a prime example. The market is dominated by five or six players, they say, and triggers are a common feature of these trades – so, if one of the bigger houses is downgraded, all hell could break loose.
“Rating triggers are, by their nature, wrong-way risk and are hard to quantify. But even more problematic is when these triggers are being used in a space where the underlying product flow is systemic. All banks will be same way round and a trigger will then catapult the bid-offer to unknown but most likely extreme levels – even more so when liquidity and capacity is also a constraint. Inflation and exotics markets are exposed to this kind of risk. We think this is a source of systemic risk. It is being used and pushed by pension funds and we are trying to dissuade the community from relying on these triggers,” says Guido Hebert, global head of rates structuring at HSBC in London.
The UK inflation swap market is intensely competitive, with bid-offer spreads typically between 2 and 4 basis points, traders say. But in stressed market conditions, the spreads can get as wide as 10bp, according to a trader at a large LDI manager. For a ￡10 billion inflation swap portfolio with an average maturity of 20 years and a ￡20 million sensitivity to a 1bp change in inflation – known as IE01 – this means paying the full bid-offer spread (5bp from mid-market) would result in a cost of ￡100 million.
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