May 7, 2013

The Tale of the Unclearable Trade - Managing Tail Risk with CVA

Watch the Video: The Tale of the Unclearable Trade

A new report authored by E. Paul Rowady Jr., Senior Capital Markets Analyst at TABB Group titled, "The Risk Analytics Library: Time for a Single Source of Truth" points to the market drivers and technical complexities behind achieving a unified view of risk, duly noting the $65 trillion in tail risk associated with unclearable swaps that will extend out another 30 years.

According to Satyam Kancharla, Numerix Chief Strategy Officer these bespoke hedges represent 12 percent of the OTC market and they touch a large group of market participants, yet much of this risk, including Counterparty risk, is poorly understood and often ignored. While quantitative metrics such as Credit Valuation Adjustment (CVA) can help, Kancharla tells TABB's Alex Tabb, only a handful of firms worldwide have implemented the process.

Weigh in and continue the conversation on Twitter @nxanalytics, LinkedIn, or in the comments section

Video Transcript: The Tale of the Unclearable Trade

Alexander Tabb (Host): TABB Group estimates that there are $65 trillion of tail risk still associated with uncleared swaps out in today’s market. That tail is going to extend for another 30 years. Where does that risk lie and how are folks managing it? I’m joined today by Satyam Kancharla, Chief Strategy Officer for Numerix. Satyam, where does this risk lie and what are people in the industry doing to manage it?

Satyam Kancharla (Guest): So Alex, this is the 12% of the OTC portfolio that’s outstanding. It is not cleared, it is not clearable. And in terms of where it lies, it lies both on the sell side and on the buy side obviously because all of these transactions are derivative transactions. They’re swaps typically, and they are in between, let’s say insurance companies and banks, or pension funds and banks, asset managers in some cases, corporates, and these are really the spoke hedges that have been put in place, in some cases they’re being put in place now. They’re long dated in nature. They’re very hard to clear, so you really have to manage them.

Tabb: Are folks managing it today? What’s the optimal mechanism for managing this much risk extending that far into the future?

Kancharla: What has been shown recently in the last several years is market risk is not the only risk you have. There’s counterparty risk, there’s funding risk, there’s liquidity risk, and these are the risks that are largely ignored at this point.

Tabb: Isn’t that taking into consideration with enterprise level risks or CVA? Doesn’t CVA try to manage this risk for the tail of these bespoke solutions?

Kancharla: Yes. CVA is definitely center stage because of whatever has happened over the last several years. What has happened after 2008 is people knew about market risk and they understood market risk but when it comes to counterparty risk, a whole new set of measures have come out which is CVA, which is credit valuation adjustment for potential future exposures, various types of limits and various types of quantitative metrics on counterparty risk. On the other hand, very few institutions except the top tier institutions, except five or six institutions worldwide have actually implemented this.

Tabb: I mean CVA from my understanding is an extremely complicated set of calculations that cover cross the gamut all asset types, looking backwards and forwards. If only five or six of the largest institutions are using CVA as a tool, what are the folks who have this outstanding risk supposed to do? These are insurance companies, some corporates. Maybe Tier II, or Tier III brokers. How could they get on top of this challenge and make sure they are not caught in the tail.

Kancharla: Well the methodologies are established, but as you point out it’s a very complicated problem. Technologically, from a data standpoint and they’re various intricacies that are involved. Which Tier I’s are some of the top banks have been able to do, but not any of the other institutions. And typically today a whole bunch of institutions are looking to solutions outside. Looking to enter products for example that could come in and help in these specific areas because it’s no longer acceptable to not have a handle on your counterparty risk.

Tabb: What is the challenge with doing the poor man’s version of CVA as opposed to the more advanced version? 

Kancharla: So Alex there are two types commonly of CVA. One is the standardized approach, which is simpler, it’s not simple. And there’s the advanced approach which is more quantitative and requires a lot more data. Now the chief problem with doing the simpler version or the standardized version is first of all, you’re not going to save on regulatory capital. The standardized approach is very conservative, so that means you might be posting millions or hundreds of millions of additional capital that you wouldn’t have to do if you were using the advanced approach. The other part of this is simply about mispricing versus the market. So just as you want to price your book correctly against the market, in any asset class in any type of financial instrument, using the simpler approach will misprice against the market, will misprice against the more advanced institutions that are able to implement the advanced methodology.

Tabb: So the advanced methodologies are much more rapid turnaround, the data is much fresher you can than get more accurate valuations of what your risk positions are. And there’s a competitive advantage to be gained from anyone who is capable of going the extra step.

Kancharla: Exactly.

Tabb: Is there a turnkey solution or vendor solution out there that can do CVA on the cheap, without having to climb the very difficult mountain of very complicated calculations and really significant methodology change?

Kancharla: Well there are a number of components of a calculation like CVA that have been productized and that are now available from vendor companies. On the other hand, there are also data issues and cultural issues and risk culture issues that of course an institution has to deal with.

Tabb: This must be very difficult for institutions because most of the institutions use multiple analytic shops. They have multiple platforms. Each desk or each product has its own vendor solution or its own bespoke to develop solutions. How can folks get on top of this and bring all of these varying sets of data together to get one single point of truth?

Kancharla: The real challenge is to defragment at an analytic level and at a data level. All of this information and analytics that an enterprise has, and really to bring that together into a central environment or perhaps an internal cloud or external cloud and then run various analytics on top of that.

Tabb: Is there usually one individual or one desk responsible for that?

Kancharla: That’s correct. And what we’re seeing as a result is some new titles appearing, some new roles appearing. For example, Architecture. What led to this stage is the organic development that has taken place over the last thirty years. So that sort of development is not going to address and solve the issues we have at hand. It’s really someone owning this and driving this.

Tabb: With $65 trillion of outstanding notional on OTC derivatives still out there on the books it’s important that we remember that the tail can’t wag the dog in this situation. Getting on top of this challenge is going to be a primary concern for everyone in the marketplace, especially considering the fact that these trades are not going away. Satyam thank you very much for joining us today. I appreciate your time.

Kancharla: Thank you Alex.      

Blog Post - Nov 07, 2011

Modeling Wrong Way Risk in CVA for Traders and Risk Managers

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