Jul 15, 2016

CVA, Brexit and Cross-Gamma

The recent vote on the Brexit has left the global economy with one major question: What Happens Next? In this video blog Vice President of Business Development and FX expert Udi Sela addresses how Brexit has impacted CVA desks as a result of cross-gamma losses. Udi also discusses potential hedging strategies to protect from future shocks, and provides insight on the impact from upcoming political events, like the US elections in November.


Jim Jockle (Host): Hi, welcome to Numerix video blog, I'm your host Jim Jockle. Looking at the Brexit fallout, as we’re only a week later, a couple challenges continue to rise in the market. Joining me today for a discussion is Udi Sela, Vice President of Business Development for EMEA. Welcome Udi, how are you sir?

Udi Sela (Guest): Thank you, thank you. Good morning to you, Jim.
Jockle:  So I want to talk about cross gamma. Especially as it relates to CVA, a big challenge that’s been kind of widely discussed in the inner circles of the banking industry and started getting a little bit into the main stream. So Udi, why don’t you give us a quick primer on what’s going on as it relates to CVA and the issues with the creation of Brexit and cross gamma.

Sela: So when we look at CVA, and the family of XVA and different valuation adjustments, well when banks need to set aside capital to hedge against counterparty defaults there are a few factors that are playing. The two most prominent are the CDS spreads and then volatility. Now we often talk about wrong-side risk, but in fact what we just found now with the Brexit was that there was a double whammy for banks trying to hedge those valuation adjustment exposures. And what happened was is, obviously the Brexit is an event that happens in, I don’t know every 10 or more years, every 20 years, and since the markets these days are so correlated, the moves were very violent and across the board (e.g. across all asset classes). So, specifically, volatility shot up, almost doubled if you like, and at the same time the CDS spreads opened. So basically the cost of insuring your counterparty risk increased and since these two (CDS spread and Volatility) are correlated it meant a very large, significant, CVA adjustments for the banks and some European Banks we’re talking in the order of 25 to 50 million dollars’ adjustment just in one day. Now, since that we’re looking at cross gammas, the hedging is almost impossible because we’re looking at cross correlation. And this is basically it, this is what happened.  

Jockle: So Udi arguably this is a political event. This isn’t a systematic shock to the financial system as we’ve seen in 2008 or other areas. There is liquidity in the market place. One could presume that, with across the banking sector, the CDS spreads outside of perhaps specific UK banks, were reacting systemically across the marketplace. How is that going to play out longer term, where a political event starts to really play out as an event or shock to the financial system?

Sela: There’s a few things to say here. So indeed the liquidity was there to support the market you know, from un-functioning. But, the bid-ask spreads in swaps and specifically CDS’s opened by a factor of seven. So basically getting in and out of positions was much more difficult. The frictions in adjusting positions or the cost of trading and hedging increased significantly. So that’s the first thing I wanted to mention. The second thing is that the central banks seem to have been ready for that and have prepared and actually provided a lot of liquidity into the market which helped significantly the market to function. We haven’t heard of any events of systems timing out because of lack of liquidity. The only thing that fell was the Asus website for purchasing in sterling so that’s fine, the markets can deal with that… And in the long term I think this would imply more out of the money hedging, exactly to hedge those systemic risks and we mentioned elections. In the UK there’s a lot of uncertainty there. There is uncertainty when and will the UK invoke the famous article 50, we don’t know whether negotiation behind the scenes to keep the UK within the European Union, are taking place. Let’s say what would happen if the UK eventually doesn’t need the European Union? Will that create a shock? Most likely yes. And then of course we have the U.S. elections in November, right. Which also can generate a huge move in the market. So I think we are to see increased volatility levels at least through the end of this year.   

Jockle: Well Udi, you neglected to mention one final shock which was the defeat of England by Iceland. Critically important.

Sela: Jim I am in London; I can see their faces.

Jockle: So Udi, I want to thank you so much for your perspective. Of course we want to talk to you as this continues to play out over the volatile summer months as well and the rolling into what’s going to be a tumultuous fall with all the elections. And of course, we always want to talk about the topics you want to talk about so please follow us on LinkedIn  or on Twitter @nxanalytics. Udi, thank you so much for your time and your insight.


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