Jan 15, 2014

From the Volcker Rule to FVA’s Impact on Trade Profitability: The Challenges We Face

With the new year upon us, Wall Street has been once again reeling over the recent news surrounding the Volcker Rule implementation, now approved to go into effect on April 1, 2014.  Despite the cold weather, financial institutions are once again feeling the heat, with strong concerns over the fact that they could face oversight by at least three different government agencies, as early as Q2 2014.

In the meantime, Wall Street practitioners are still facing a slew of other concerns as we kick-off the first quarter of 2014—ranging from best practices in the handling of Credit Support Annex (CSAs) and central clearing, to OIS discounting and the ongoing navigation of Credit Valuation Adjustments (CVA) and Funding Valuation Adjustments (FVA). Underlying all of this, of course, are risk management, pricing complexities and the continuing need to change disparate or inadequate systems and processes to meet the latest onslaught of regulatory requirements. Given this, and evermore changes in the pipeline for the new year, it remains important to keep our eye on the prize…How is all of this going to impact an institution’s bottom line—profitability?

In moving toward an answer to this question, one way too complicated to solve in this single commentary, we’ll begin by breaking things down, one challenge at a time. Since, our clients have been asking a lot of questions about FVA recently, we’ll focus on trade profitability from an FVA perspective.

Before concerns surrounding FVA were overshadowed by more recent Wall Street dramas, most practitioners had come to accept FVA as a real charge impacting the profitability of their trades, but remained uncertain over the handling of certain aspects of FVA.

One debate that still persists involves how to handle the FVA charge from an accounting and a regulatory perspective. Should the mark-to-market (MtM) value include the FVA charge? According to Fair Value Accounting, the value to report for a trade is the value that the free market would pay in an ordinary transaction for that derivative today. However, with three ways of thinking about this—unwinding, novation, holding the trade to maturity—what is the correct solution?  As of today, no requirement exists from any accounting body to include FVA in regulatory accounting. However, while there is still no official consensus on how to handle the FVA charge from an accounting perspective, this issue cannot be ignored. Regulators and accountants remain on the sidelines for now, waiting for a consensus among practitioners. It will be very interesting to see what the outcome will be in 2014 for FVA—and many of the other challenges we all face in the upcoming year!

In the meantime, to address many of our clients’ current concerns, we’ve decided to take a deeper dive into the FVA relationship as part of the funding process—including how to incorporate a ‘funding charge’ in pricing to reflect a firm’s true cost of funding.  Numerix Chief Strategy Officer & SVP Satyam Kancharla recently published a research paper addressing these issues, while also exploring the basics of OIS discounting and FVA for OTC derivatives and the relationship between the two concepts. 
This paper also includes a case study that highlights the potential impact of FVA on trade profitability. Mr. Kancharla concludes that FVA is a real charge, affecting the profitability of trades. Therefore, FVA should also impact decision-making about the trade. In the end, we come to see why it is imperative to know this cost in order to make the best business decisions. 

To learn more about FVA and its impact on trade profitability, download the full Numerix Whitepaper: "The OIS & FVA Relationship – The Evolution of OTC Derivative Funding Dynamics."

- See more at: numerix-blog/2014/01/from-the-volcker-rule-to-fvas-impact-on-trade-profitability-the-challenges-we-face-in-2014#sthash.mPcL29iH.dpuf

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