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Credit value adjustment: Why it matters in Asia
In recent years, the global financial services industry has seen regulatory changes that have resulted in more stringent reporting and compliance requirements. The high-profile, and at times controversial, nature of rules such as Dodd-Frank and Emir have perhaps overshadowed the 2013 rollout of new global accounting standards
10 Oct 2014

In recent years, the global financial services industry has seen regulatory changes that have resulted in more stringent reporting and compliance requirements. The high-profile, and at times controversial, nature of rules such as Dodd-Frank and Emir have perhaps overshadowed the 2013 rollout of new global accounting standards for measuring fair value under IFRS 13. One of the key features of the IFRS 13 requirements is to accurately measure the credit value adjustment (CVA) for OTC derivative positions.

 

While large banks in Asia have long since developed sophisticated solutions for measuring and hedging CVA, many of the buyside and regional banks are not compliant with IFRS 13 standards. The degree of audit focus placed on CVA differs dramatically across the region but audit scrutiny in 2014 is increasing and in some countries at a significant pace.

 

IFRS 13 provides uniform, global standards for measuring fair value. Under these standards, firms are now required to include the possible impact of one or both parties to a trade defaulting on some or all of their contractual obligations when measuring the fair value of their OTC derivatives exposure. This means that fair value calculations must now incorporate CVA, which measures one entity's net exposure to the credit risk of its counterparty, as well as debt value adjustment (DVA), which measures the entity's own credit quality. The level of sophistication required to calculate CVA is also increasing with pressure from the audit community to have calculations using market-based pricing and simulation approaches.

 

"IFRS 13 is required to be applied by all firms. This means that firms in all industries, regardless of whether they are banks, funds or corporates, are subject to CVA and DVA calculations as long as they have OTC derivatives in their book. This often creates a challenge for many firms due to the complexity involved," says Sky So, director of financial services risk management at EY Advisory Services. "In the past, many firms relied on counterparty or bank monthly statements to obtain the fair value of their derivatives for reporting purposes. This may no longer fulfill IFRS 13 requirements if appropriate CVA and DVA are not incorporated in the fair values provided."

 

"These new regulations are a product of the global financial crisis," adds Ross Allen, director and head of valuations for APAC at Markit. "The International Accounting Standards Board is addressing the varied and inconsistent nature of fair value measurement that had exacerbated the uncertainty and confusion around valuing assets. The implementation of IFRS 13 presents challenges to many market participants in Asia and the use of in-house approaches are either too simplistic or incur significant internal infrastructure and implementation costs."

 

Industry best practice CVA calculation approaches require large and up-to-date market datasets, complex pricing models and simulation engines running on heavy IT infrastructure. However, given resource constraints and implementation urgency, smaller Asian banks and buyside institutions, including insurance firms and non-financial corporates, have resorted to quick-fix, in-house implementations using simplified approaches and non-market implied data. Increasingly, these simplified approaches have been scrutinized by the auditors with the expectation that remediation plans will be put in place.

 

"Some firms consider CVA and DVA not material enough for them to measure accurately when IFRS 13 was adopted last year. However, we should stay on guard because the size of CVA and DVA may move significantly as default probability, market data, remaining tenor and portfolio structure change," So says.

 

Institutions with the greatest need to estimate CVA for accounting purposes are insurance companies, pension funds, corporates and asset managers, as they often have exposure to OTC derivatives which are not fully collateralized. Although these firms may have existing risk management systems for market risk (VaR), the market data, calibration and analytical requirements for CVA and DVA calculations are quite different. The lack of market-standard models or methodologies for incorporating CVA and DVA in fair value measurements for OTC derivatives adds to the complexity.

 

"What we are hearing from our buyside customers is that the old methods of simplified CVA calculations using spreadsheets and limited market data inputs are no longer viable, as they aren't dynamic, and don't take into account constant market changes," notes Allen. "The possibility of over- and under-estimation of CVA and DVA is very real, resulting in biased valuations. A viable and cost-effect alternative is required."

 

To bridge this gap, firms need to either build the expertise, systems and methodologies in house or outsource the requirement to a service provider. The first option can be costly and prohibitive for smaller firms. The second option has the benefit of lower cost and quicker turnaround, but should be flexible and transparent so that firms have clear visibility of the process and calculations driving the results.

 

Markit is one firm offering a fully hosted solution that supports best practice in the adoption of IFRS 13. "Our independent, efficient and transparent service helps firms meet the requirements of this accounting standard. Markit has provided credit default swap data for a decade and has recently developed a methodology for market-data based proxies for illiquid counterparty credit curves. By combining extensive credit data, an award winning CVA simulation engine and the ability to on-board customers and produce CVA reports quickly, we have a valuable solution for firms seeking a quick, cost-effective and scalable hosted solution," concludes Allen.

 

As year-end auditing looms, buy-side firms should engage with their auditors to ensure they have the right tools and processes in place to comply with IFRS 13.

 

For more information on Markit's CVA service, visit www.markit.com/PV-CVA


 

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