06 March 2013

Risk.net: Europe edges towards three-pronged credit valuation adjustment (CVA) exemption

European banks are on the verge of being granted a sweeping exemption to the CVA capital charge contained in Basel III, after the EU's finance ministers this week endorsed the result of drawn-out three-way wrangling between the Council of EU, members of EP and EC.

The text produced by the so-called trilogue negotiations has not been published, but three people involved in the negotiations say the three-pronged CVA exemption that appeared in the parliament's earlier drafts of the rules – covering trades with corporates, pension funds and sovereigns – has been included in the final compromise text. That appears to be borne out by a recent version of the document, obtained by Risk.

The plans are already being welcomed by dealers. "Europe has clearly taken the right approach with the CVA exemptions", says the head of one European bank's CVA desk. His counterpart at another European bank calls it "an important step".

If the exemption appears in Europe's final Basel III rules, it will create a divide with other jurisdictions where final rules incorporate a blanket CVA charge, such as Australia, China, Japan, Singapore and Switzerland. No CVA exemption appears in Basel III proposals in the US.

But the mooted CVA exemption will have a more direct impact on the economics of the derivatives business, and dealers have been waiting for certainty on the scope of the charge for over a year. Both the Council of the EU and the European Parliament went through a number of iterations of the charge in their own versions of the text – which falls into two parts, the fourth Capital Requirements Directive (CRD IV) and the Capital Requirements Regulation – and began trying to reconcile them when the trilogue negotiations started in June last year.

A version of the compromise text relating to the CVA charge, dated February 6, includes a number of cross-references with the European Market Infrastructure Regulation (EMIR), the EU's new rules on clearing for over-the-counter derivatives. That text refers to exemptions for non-financial counterparties, as defined in article 2, paragraph 9 of EMIR, as well as counterparties referred to in article 2, paragraph 10, and article 1, paragraphs 4a and b plus paragraphs 5a to c. Those last three paragraphs in EMIR cover a variety of pension schemes, and a host of different sovereign entities – members of the European System of Central Banks are mentioned specifically, as well as the Bank for International Settlements, the European Financial Stability Facility and the European Stability Mechanism.

The exemption would also apply to intragroup transactions – although a caveat was added in the February 6 text, meaning the CVA charge would still apply if "Member States enact national laws requiring structural separation within a banking group, in which case competent authorities may require those intragroup transactions between the structurally separated institutions to be included". That appears to refer to the ring-fencing of banks' trading and retail businesses – which is planned in the UK and is also being debated at the EU level.

Proponents of an exemption argued the CVA capital charge didn't make sense given the clearing exemption for corporate and sovereign clients that is contained in EMIR. Pension funds also have a temporary exemption. In all three cases, it was argued these market participants lack the large stocks of liquid assets needed to satisfy clearing house demands for initial and variation margin. But uncleared, uncollateralised trades attract a big CVA capital charge unless the exposure can be hedged with credit default swaps (CDSs) – meaning corporates, for example, would have escaped the margin demands associated with clearing, only to face a hike in trading costs.

In addition, critics worried about pro-cyclicality. The charge could be hedged by CDSs, but also has to be calculated using credit spreads as an input, creating a potential feedback loop – widening spreads would result in a higher CVA charge, and the higher charge would spur more banks to buy CDS protection – theoretically driving spreads wider.

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