Optimal Funding Strategies for Counterparty Credit Risk Liabilities

Abstract

The Dodd-Frank Act and the recently proposed Basel Committee regulatory framework for CCPs are a game changer for counterparty credit risk management. The practice of charging an upfront fee as a Credit Valuation Adjustment (CVA) to provision against counterparty credit risk liabilities is being abandoned as it was blamed for as much as two thirds of the losses recorded during the financial crisis. Instead, a key role will be played by margin financing, whereby periodically marked-to-market revolving lines of credit are used to cover margin variations on a cross-product basis. The emerging pay-as-you-go funding strategy for counterparty credit risk liabilities has a fair value equal to the CVA upfront fee but an entirely different risk profile. Using margin financing, the process for expected loss is locked at zero by construction and CVA volatility risk is passed on to the counterparties themselves. As a side effect, wealth is transferred from bankrupt entities to healthy ones. Moreover, in a Dodd-Frank world, there is no DVA because there is no counterparty credit risk and the paradoxes of DVA accounting and CSA discounting are removed. To further optimize the funding strategy, interest in flows from portfolios of margin revolvers can be redirected through securitization vehicles to a hierarchy of bond holders to which tranches of risk are apportioned. With this construction, banks can purchase nearly full counterparty default protection from capital markets at a fair cost equal to the CVA, the theoretical optimum. The only remaining risk is concentrated in the equity tranche as there could be a mismatch between interest inflows and outflows.