This thesis aims at studying the recent regulatory reforms on deriva-tive markets, namely the central clearing obligation under EMIR and CVA capital charges under Basel III framework. This study shows that the most standardised and liquid classes of OTC derivatives are expected to be cleared via a CCP; the substitution between exchange-traded and OTC derivatives market is likely to take place; and changes in margining practices would transform the counterparty credit risk into liquidity risk. Regarding to the new CVA capital requirement, the examples illustrate market criticism that Basel’s formula ignores market hedges. In addition, it is not always optimal to complete hedge market risks since it would probably cause the CVA volatility to fluc-tuate more.

1. The impacts of recent OTC derivatives markets
regulatory reform
Thu-Phuong DO
Universite d'Evry Val d'Essonne
Master 2 Gestion des Risques et des Actifs
16 October 2014
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3. Overview
1 The recent regulatory reforms on OTC derivatives markets
The pre-crisis conditions and objectives of reform
Key elements of EMIR
Market changes and issues under debate
2 Basel III and regulatory capital requirement for OTC derivatives
Revisions in Basel III regarding OTC derivatives
Two methods for calculating CVA charges
Hedging CVA
3 Case study :Trade-o between regulatory capital and earnings
Absence of wrong-way risk
Discussion
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5. The recent regulatory reforms on OTC derivatives markets The pre-crisis conditions and objectives of reform
Market conditions (1)
Condition 1
The OTC derivatives markets outweigh the ETD markets both in terms of
volume and notional value.
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7. The recent regulatory reforms on OTC derivatives markets The pre-crisis conditions and objectives of reform
Market conditions (2)
Condition 2
Given the widen gap between Euribor and Eonia, Euribor is no longer
considered proxy for risk-free rate for the purpose of discounting future
cash
ows in derivative pricing. The dual curve discounting practice
became the new standard in derivative market.
Figure: The evolution of Euribor and Eonia rate from Dec 2005 to Jul 2014
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9. The recent regulatory reforms on OTC derivatives markets The pre-crisis conditions and objectives of reform
Market conditions (3)
Condition 3
The Credit Counterparty Risk (CCR) was not suciently captured
under Basel II framework.
The Wrong Way Risk was often ignored in model calibration.
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11. The recent regulatory reforms on OTC derivatives markets The pre-crisis conditions and objectives of reform
Regulatory reforms
In December 2012, the European Commission adopted the technical
standards for the Regulation on OTC derivatives, central
counterparties and trade repositories, known as European Markets
Infrastructure Regulation (EMIR) ;
Basel III framework was implemented in Europe via CRR/CRD IV,
addressing the OTC derivatives market issues by introducing a new
capital requirement for losses resulting from CVA.
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13. The recent regulatory reforms on OTC derivatives markets Key elements of EMIR
Scope of regulation (1)
Product scope : Derivative instruments
A derivative includes any option, future, swap, forward and other
derivative contract relating to securities, currencies, interest rates,

14. nancial indices, commodities,

15. nancial contract for dierences and
credit default swap. [MiFID]
The classi

16. cation of derivatives (either over-the-counter or
exchange-traded) is important in determining the compliance
obligations.
Question : Are FX Forwards under the scope of regulation of EMIR ?
FX Forwards are viewed as a non-derivative product in the UK but not
elsewhere in Europe.
FX market is highly liquid ;
The physical settlement which is common in FX transactions reduces
the credit risk.
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18. The recent regulatory reforms on OTC derivatives markets Key elements of EMIR
Scope of regulation (2)
Market Participants : EU entity or Third country entity
2 categories of market participants :
EU entity, including :
Financial counterparty (FC) ;
Non Financial counterparty (NFC) with 2 sub-categories, either NFC+
or NFC-.
Third country entity
NFC+ or NFC- : Why is it important ?
The categorisation as NFC+ or NFC- has become important as EMIR
clearing and collateral obligations come into eect. For example :
Transaction FC NFC+ : clearing obligation ;
Transaction FC NFC- : exempted from clearing obligation.
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20. The recent regulatory reforms on OTC derivatives markets Key elements of EMIR
Clearing Obligation
The two parties enter into two separate contracts with a CCP which
takes over each party's positions under original contract. The CCP is
now the counterparty to each of the original parties.
3 types of clearing models :
Member clearing
Client clearing
Indirect clearing
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22. The recent regulatory reforms on OTC derivatives markets Market changes and issues under debate
Most standardised and liquid classes of OTC derivatives are expected to be
cleared via a CCP
Hull (2010) divided the OTC derivatives transactions into four categories
to examine the possibility of being cleared :
Plain vanilla derivatives with standard maturity dates ;
Plain vanilla derivatives with non-standard maturity dates ;
Non-standard derivatives for which there are well-established pricing
models ;
Highly structured deals.
The

23. rst two categories have the high chance to be cleared as the variables
for pricing are observable in the market or easily interpolated (e.g. vanilla
interest rate swaps, index CDS, and certain single-name CDS).
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25. The recent regulatory reforms on OTC derivatives markets Market changes and issues under debate
Figure: Current state of central clearing on FRA and CDS
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27. The recent regulatory reforms on OTC derivatives markets Market changes and issues under debate
Substitution between ETD and OTC : futurisation of swap
The Initial Margin treatment for Futures is much favourable than that
of Swaps (i.e. 1-day VaR vs. 5-day VaR).
The clearing obligation may eliminate the main advantages of OTC
derivatives as a low cost and highly tailored product.
e.g. 2 new swap futures products : Eris IMM-dated contracts, CME
Deliverable Future Swap.
Margin requirement : From counterparty credit risk to liquidity risk
The demand for high-quality assets may increase substantially due to
the need for Variable Margin exchanges.
This trend should be considered in the context of other regulatory
framework, i.e. the liquidity ratios under Basel III framework.
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29. Figure: Example of potential variation margin requirement

30. Basel III and regulatory capital requirement for OTC derivatives Revisions in Basel III regarding OTC derivatives
CCR vs. CVA charge
Counterparty Default Capital
Charge
1 Introduced under Basel II
framework to address the
counterparty default
2 The capital charge is the

31. xed percentage of RWA,
with EAD is determined via
Current Exposure method or
Internal Model Method
(with EEPE approach).
3 Objective : capture the
default of derivative
contract's counterparty
CVA Capital Charge
1 Introduced under Basel III
framework to address the
volatility of fair value
adjustments of derivative
contracts
2 Under Standardised Approach,
EAD is estimated from two
components : RC and PFE ;
Under Advanced approach, the
EE is used to calculate the CVA.
3 Objective : capture the volatility
driven by the market factors that
aect the derivative exposures
and credit spreads changes.
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33. Basel III and regulatory capital requirement for OTC derivatives Two methods for calculating CVA charges
Standardised Approach
Formula
CVA = 2:33
p
q h
P
(
i Mhedge
i Bi ) wind Mind Bind )2+
i 0:5 wi (Mi EADtotal
P
i (Mi EADtotal
i Mhedge
i 0:75 w2
i Bi )2
Interpretation [Pykhtin (2012)]
qP
H = 2:33
i 2
i + 2
P
i ;j i j 2 ind ind
P
i i + 2
ind
CVA : 99% con

34. dence P
interval of the normally distributed random
variable Y =
i Ni Nind .
i Mhedge
Volatility of the i-th asset : i = wi (Mi EADtotal
i Bi )
Volatility of index is ind = wind Mind Bind
Assets are assumed to correlate with each other with correlation of
25%, and correlate with the index with the correlation of 50%.
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36. Basel III and regulatory capital requirement for OTC derivatives Two methods for calculating CVA charges
Advanced Method
Formula
CVA = LGD
Pn
i=1
EEti1+EEti
2 max(qc (ti1) qc (ti ); 0)
EE(t) : discounted expected exposure at time t
qc (t) = esc (t)t
LGD : counterparty survival probability at time t
LGD : How is the Loss Given Default de

37. ned ?
LGDmkt needs to be consistent with the derivation of the hazard rates {
and therefore must re
ect market expectations of recovery rather than
mitigants or experience speci

38. c to the

39. rm. [BCBS,2012]
Interpretation
The fact that the Advanced Method uses credit spreads and their
volatilities rather than the prede

40. ned regulatory weights makes this
method more consistent with other VaR methods.
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42. Basel III and regulatory capital requirement for OTC derivatives Hedging CVA
Objectives Eligible Instruments (1)
Objectives of hedging
Reducing the sensitivity resulting from their own credit spread
uctuations and those of their counterparties ;
Reducing the Maximum PFE at given con

43. dence level.
The two goals are con
icting and cannot be achieved simultaneously, thus
balancing them is needed.
Eligible hedging instruments
Only CDS is eligible to reduce CVA charges under Basel III :
Single-name CDS
Index CDS
Contingent CDS (CCDS)
The Basel Committee considers only credit spread variations as the source
of CVA variations.
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45. Basel III and regulatory capital requirement for OTC derivatives Hedging CVA
Objectives Eligible Instruments (2)
What are the problems associated with the eligibility of hedging
instrument ?
For the majority of counterparties that have no CDS or a contract that
trades infrequently, there are two problems associated with this hedging
eligibility.
Hedging with index CDS on entity whose default probability strongly
correlates with the underlying exposure
Consequence : This hedging strategy may not always be a good oset
for the CCR.
A proxy for credit spread has to be used to plug into the Advanced
method's CVA formula.
Consequence : The dealers as the result would end up hedging CVA by
index containing the proxy name that may not be well correlated to the
underlying exposure.
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47. Basel III and regulatory capital requirement for OTC derivatives Hedging CVA
Hedging diculties : Accounting vs. Regulatory CVA
Accounting CVA
1 Under FAS 157 and IFRS 13,
CVA has to be recognised as
the adjustment to fair value
of derivative portfolio.
2 Certain large banks have
utilised complicated
methodology to hedge the
CVA volatility by taking into
consideration every market
risk factor aecting the
derivative future values.
Regulatory CVA
1 Regulatory CVA is calculated by
highly speci

48. c formula provided
by the Basel Committee with
method choice conditional on
regulatory approval.
2 Only credit spread is captured
as the source for CVA volatility
under Basel III.
The dierences in CVA recognition under Basel III and IFRS result in the
diculties in designing CVA hedging strategies.
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50. Basel III and regulatory capital requirement for OTC derivatives Hedging CVA
Hedging diculties : Risk-neutral vs. Real world probability
Risk-neutral probability
1 Used for pricing purposes to
ensure no-arbitrage
opportunities ;
2 Assumption : Investors are
risk neutral ; risk premium is
null.
3 Useful in designing
strategies for hedging
purpose as it re
ects the
market price of instruments.
Real world probability
1 Critical for risk management
purpose to make inference on
the future value of derivatives ;
2 Investors are actually risk
averse ; risk premium is positive.
3 Useful in CCR assessment and
CVA estimation.
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52. Case study :Trade-o between regulatory capital and earnings Absence of wrong-way risk
Example
We consider the example of a portfolio composing of two swaps with two
dierent counterparties (Ccty 1 and Ccty 2) of bank X. The bank decides
to hedge half of the market risk associated with the variations of interest
rates of
oating leg by entering into an opposite swap with the same
counterparty. We consider hence two identical vanilla swap portfolios.
Portfolio Ccpty Description Notional
1 1 10Y, Pay 1.5% - Receive Euribor 1Y+10bps 1 mil
1 1 10Y, Receive 1% - Pay Euribor 1Y+15bps 0.5 mil
2 2 10Y, Pay 1.5% - Receive Euribor 1Y+10bps 1 mil
2 2 10Y, Receive 1% - Pay Euribor 1Y+15bps 0.5 mil
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54. Case study :Trade-o between regulatory capital and earnings Absence of wrong-way risk
Monte Carlo simulation (1)
CVA calculation
CVA = (1 R)
P
k e(tk )[P(tk ) P(tk1)]
R : constant recovery rate (40%)
P(t) : unconditional cumulative probability of default up to time t
e(t) : discounted expected exposure at time t
Hull-White short rates model
drt = ((t) (t)r (t))dt + dWt
(t) is a function of time determining the average direction in which
the short rate (r) moves ;
is the mean reversion rate ( = 0:0425) ;
is the annual standard deviation of the short rate ( = 0:0104)
The market scenarios are generated using HW1F function in Matlab with
2 parameters and .
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56. Case study :Trade-o between regulatory capital and earnings Absence of wrong-way risk
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58. Case study :Trade-o between regulatory capital and earnings Absence of wrong-way risk
Monte Carlo simulation (2)
Exposure calculation
The mark-to-markets of swap portfolios are approximated at each
simulation date using functions hswapapprox and
hcomputeMTMValues in Matlab.
LHS : Netting agreement for ccty 1 - No netting agreement for ccty2
RHS : Netting agreement for both counterparties
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60. Case study :Trade-o between regulatory capital and earnings Absence of wrong-way risk
Monte Carlo simulation (3)
Probability of Default
The probability of default is deduced from CDS spreads (using
cdsbootstrap function in Matlab)
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62. Case study :Trade-o between regulatory capital and earnings Absence of wrong-way risk
Result (1)
CVA level for swap portfolio
The CVA level actually reduces in the case of netting agreement which
illustrates the market criticism that regulatory CVA calculation ignores
market hedges.
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64. Case study :Trade-o between regulatory capital and earnings Absence of wrong-way risk
Result (2)
CVA volatility
The CVA volatility

65. rst diminishes due to the decreasing pro

66. le of
Discounted Expected Exposure and then escalates. The complete market
hedge is not always bene

67. cial.
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69. Case study :Trade-o between regulatory capital and earnings Discussion
Discussion (1)
Estimation of probability of default
Sokol (2012) listed out four relevant proxies which can be used to calibrate
the probability of default from best to worst :
From CDS spread (if CDS is traded) ;
From bond spread (if bond is traded) ;
From rating transition matrix ;
From comparables (as a last resort).
Cash collateral alongside a contingent

70. nancial guarantee - CCCFG
The CCCFG is supposed to bridge the gap and works well under both
regimes of CVA.
The cash collateral reduces the exposure, thus diminishes CVA level.
The contingent element is treated as

71. nancial guarantee which is not
carried at fair value according to IFRS.
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73. Case study :Trade-o between regulatory capital and earnings Discussion
Discussion (2)
Example of CCCFG between 3 counterparties
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75. Case study :Trade-o between regulatory capital and earnings Discussion
Discussion (3)
Debt Value Adjustment - DVA
Current status : DVA has been ignored by Basel III framework
We witnessed a considerable
uctuation of banks' credit spreads
during the crisis that drove their earnings from loss to pro

76. t.
The treatment of DVA along with its potential impacts on regulatory
capital and earnings are an interesting issue to study afterwards.
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78. THANK YOU FOR YOUR ATTENTION !
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80. Bibliography
Bibliography
Basel Committee on Banking Supervision, Basel III : A Global Regulatory
Framework for More Resilient Banks and Banking Systems, December 2010.
Basel Committee on Banking Supervision, Basel III counterparty credit risk and
exposures to central counterparties { Frequently asked questions, December 2012
(Updated of FAQ published in November 2012)
REGLEMENT (UE) No 648/2012 DU PARLEMENT EUROPEEN ET DU
CONSEIL du 4 juillet 2012 sur les produits derives de gre a gre, les contreparties
centrales et les referentiels centraux (Texte presentant de l'inter^et pour l'EEE)
Elhajjaji O., Subbotin A. (2013), CVA with Wrong Way Risk : Sensitivities,
Volatility and Hedging, Working paper, October 7th 2013
Alexander Sokol, Numerix/CompatibL, PRIMIA Global Risk Conference 2012, NYC
Pykhtin M. (2012), Model foundations of the Basel III standardised CVA charge,
Risk magazine, July 2012
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82. Bibliography
Bibliography
Pykhtin M., Rosen D. (2010), Pricing Counterparty Risk at the Trade Level and
CVA Allocations, Finance and Economics Discussion Series, October 2010
Hull J., White A. (2012), CVA and Wrong Way Risk, Financial Analysts Journal,
Vol 68, No.5 (Sept/Oct 2012), p.58-69
Hull J. (2010), OTC derivatives and central clearing : Can all transactions be
cleared ?, Financial Stability Review, 2010, issue 14, p.71-78
Gregory, J. (2012), Counterparty Credit Risk and Credit Value Adjustment : A
Continuing Challenge for Global Financial Markets,Wiley, Second Edition
Source data Euribor, Eonia, CDS, etc from Bloomberg
www.mathworks.fr, www.fincad.com
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