ISDA Chief Executive Officer Scott O'Malia offers informal comments on important OTC derivatives issues in derivatiViews, reflecting ISDA's long-held commitment to making the market safer and more efficient.

If something is worth doing, it’s worth doing right. And there’s no doubt establishing capital requirements for credit valuation adjustment (CVA) is worth doing. After all, a large portion of the losses during the financial crisis were attributable to a deterioration in counterparty credit risk, which wasn’t capitalized. The question is whether CVA capital requirements as they stand are appropriate and risk-sensitive. Recent analysis suggests not.

ISDA recently conducted a quantitative impact study (QIS) on the CVA rules based on industry data. While the results are subject to non-disclosure agreements, they clearly show the rules as they stand would lead to an inappropriately sharp increase in capital requirements for derivatives businesses. This could result in higher costs for derivatives end users, and could impede their ability to access derivatives to hedge their risks.

One of the big issues relates to the poor recognition of CVA hedges – specifically, those that employ credit default swap (CDS) indices and proxy single-name CDS. Because of this poor recognition, exposures hedged at the portfolio level with an index or a proxy could actually end up attracting a higher capital charge than those without any hedge at all – a bizarre outcome that would have a negative impact on the efficiency of many hedging strategies.

A lack of convergence between regulatory CVA and market practice is another problem, particularly in the use of a margin period of risk within the CVA rules (minimum 10 days) – with the result that CVA capital is higher than appropriate in some cases. The framework is also conservatively calibrated and insufficiently granular. For example, there are only two risk weights for counterparty credit exposures to financial institutions, even though this covers a wide range of different entities, including banks, hedge funds, asset managers and pension funds.

Fortunately, we believe many of the issues can be resolved by very specific changes to the existing CVA framework. ISDA has presented the QIS results, along with industry proposals for revisions, to the Basel Committee on Banking Supervision. We hope this prompts regulators to relook at the issue and launch another consultation to tackle the outstanding issues. This would be a much better outcome than leaving flaws in the framework, which could ultimately result in national authorities making their own modifications.

We recognize the clock is ticking, and regulators may be concerned about reopening a completed rule book that is due for implementation in January 2022. But the targeted revisions that are being proposed should be achievable within the existing time frame.

The industry wants this to be done right. If that means another consultation to iron out teething problems, then surely that’s time well spent.

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