The credit valuation adjustment (CVA) capital charge is just one ingredient of the overall Basel III framework, but it’s a critical one for derivatives. CVA is a big driver of derivatives risk-weighted assets, meaning an incorrectly calibrated set of rules can have an outsized impact on the ability of end users to hedge their risks cost effectively. Ensuring the framework has the correct balance between risk sensitivity, consistency and simplicity has therefore been a top priority for ISDA – and the latest targeted revisions from the Basel Committee on Banking Supervision are an important step in the right direction.

The final CVA capital standards were published in December 2017, but impact studies by ISDA made clear that the rules as they stood would have resulted in a disproportionate increase in capital requirements, potentially affecting the ability of end users to access derivatives markets. To its credit, the Basel Committee recognized the issue, and consulted on a targeted set of revisions last November, with the aim of better aligning the CVA framework with the final market risk rules and recalibrating overall capital requirements under the CVA standardized (SA-CVA) and basic (BA-CVA) approaches.

The final rules, published earlier this month, incorporate all of the proposed modifications within the consultation paper, as well as reflecting some of the industry feedback. Together, the changes should lead to some improvement in risk sensitivity and ensure better alignment of capital requirements and economic risk – although it’s too early to assess the full impact of the rules.

One of the critical changes is a reduction in an SA-CVA multiplier from 1.25 to 1. Originally proposed to compensate for a perceived higher level of model risk in the calculation of CVA sensitivities, ISDA has long argued that a 25% add-on to CVA capital requirements is not justified. That’s because the calculation of CVA sensitivities is no more complex than for market risk sensitivities, while the SA-CVA approach simplifies the estimation of CVA risk by using conservative assumptions largely set by supervisors. Combined with reductions in certain SA-CVA risk weights to align the CVA framework with the market risk rules, the change will help achieve the goal of recalibrating the framework and reducing the excessive burden that would have been placed on market participants.

The final rule also introduces a scaler of 0.65 for the overall BA-CVA requirement. This was introduced to ensure there is an appropriate level of calibration between BA-CVA and SA-CVA approaches.

Another important modification is the exclusion of certain securities financing transactions (SFTs) and client cleared derivatives from CVA capital requirements under specific circumstances. As ISDA had argued, banks would only incur losses on SFTs and client cleared transactions if there is a default, and this is already fully covered by the counterparty credit risk (CCR) rules. Better alignment of the CVA and CCR rules will help to prevent a potential double count in capital charges.

Meanwhile, a reduction in the supervisory floor for the margin period of risk (MPOR) for certain SFTs and client cleared transactions from 10 to five business days ensures better alignment between regulatory CVA and accounting practices  – although the MPOR of 10 business days for all other derivatives transactions remains unchanged from the 2017 rule.

Critically, the Basel Committee also recognized the importance of index hedges. Given the lack of liquidity in many single-name credit default swap contracts, firms typically use indices as a proxy to hedge their CVA risk at the portfolio level. The final rules replicate the market risk framework by introducing new index buckets in the counterparty credit spread risk class, the reference credit spread risk class and the equity risk class for SA-CVA. For credit and equity indices that satisfy certain liquidity and diversification conditions, firms will now have the ability to calculate CVA capital based on the index buckets rather than looking through to the underlying names.

All in all, the changes appear to represent an improvement on the 2017 framework – although ISDA had called for further granularity in the risk buckets for financial institutions to better reflect differences in the risk profile between different types of organizations (for example, pension funds and hedge funds). Also as part of its consultation response, ISDA had proposed further amendments to the index buckets, aggregation formula and a reduced MPOR for all derivatives to better reflect the economic risks of CVA and to incentivize prudent hedging practices.

The next step is implementation. As we head towards the 2023 start date, ISDA and its members will work with national authorities to ensure the rules are rolled out appropriately and consistently.