RMAPWCSurvey_EXE_Summary

RMA and PwC on Survey on Non-Libor Discounting of Derivatives: Executive Summary
Copyright © 2013 by The Risk Management Association
All rights reserved. Printed in the U.S.A.
RMA and PwC Survey on
Non-Libor Discounting of
Derivatives:
Executive Summary

Market Risk Council
Chairman
Murray McIntosh Senior
Vice President
CIBC
Toronto, Canada
Ken Abbott Managing
Director
Morgan Stanley
New York, NY
Thomas J. Gregory
Managing Director
J.P Morgan
New York, NY
Mark Nuttall
Head of Market &
Liquidity Risk NY
Commerzbank AG
New York, NY
Kevin D. Oden
Head of Market Risk
Wells Fargo Securities
Charlotte, NC
Paul P. Sassieni
SVP/Cr Policy-Int’l Risk
Northern Trust
Chicago, IL
RMA STAFF
Fran Garritt
Associate Director
1801 Market Street,
Suite 300
Philadelphia, PA 19103
215-446-4122
fgarritt@rmahq.org
Rosemarie Casler
Administrative Coordinator
1801 Market Street,
Suite 300
Philadelphia, PA 19103
215-446-4081
215-446-4000 (fax)
rcasler@rmahq.org
Executive Summary
RMA’s Market Risk Council, working with PriceWaterhouseCoopers (PwC),
developed and carried out a survey of financial institutions, seeking to learn the
status of their transition to non-Libor discounting. The findings, which included
ranges of practices and standards used, are reported in this executive summary.
In the aftermath of the financial crisis, institutions were forced to revisit their
pricing and business models for derivatives transactions. Financial institutions
worldwide are in the process of transitioning from a pre-crisis, universal
approach of discounting derivatives transactions using the London Interbank
Offered Rate (Libor) to the current practice of discounting based on 1)
collateral currency and type in the Credit Support Annex (CSA) of ISDA
agreements or 2) cost-of-funding rates. This transition has proved to be fraught
with methodological, technological, and operational challenges. Moreover, the
pace of the transition is vastly different from geography to geography and
between institutions at different tiers of market participation.
The results of the survey RMA conducted with PwC provide insights into
common industry practices and the degree to which techniques have achieved
general acceptance and consistency. The survey results also offer useful
benchmarking data.
The survey included sections for respondents to describe what impact, if any,
the recent credit crisis, market disruptions, and Libor-related irregularities have
had on their approach to valuing derivatives.
The survey consisted of the following parts:
• Overall approach to the transition and its current status.
• Collateralization and derivatives pricing and valuation.
• Non-collateralized derivatives transactions pricing and valuation.
• Impact of the new pricing and valuation on risk management.
• Addendum on related topics.
A total of 43 financial institutions based in North America, the United
Kingdom, Europe, Asia, and Australia completed the Web-based survey, which
was written by PwC and RMA and hosted by RMA. The survey, conducted
over the winter/spring of 2013, contained over 100 questions, split between
multiple choice and written responses. Participants received an email invitation
with a unique passcode directing them to a URL address. The passcode was
embedded in the URL to ensure only one response per institution.

Overview of the Main Results
Because of the small sample sizes available in the study, no attempt was made to
conduct statistical analysis of the results. Instead, phrases such as “a few,” “about
half,” “most,” or “the great majority of respondents” describe the main results of
the survey.
To determine the leading-practices, we identified a small sample of participants
characterized by the size of their trading books, the number of daily trades, and
RWA allocation to the trading books. Nine of the 43 institutions were selected
using these characteristics to form the pool of leading practitioners. Responses
from this pool were included in a special appendix to the report, covering the
leading-practitioner pool. Institutions in the leading practitioner pool were not
revealed to preserve confidentiality.
Overall Approach to the Transition and Current Status
The majority of respondents described the status of their transition to non-Libor
discounting as either partially completed or in progress. A small group of
institutions was still in the planning and ongoing-effort stages, while a smaller
group considered its transition fully complete. The latter would mean full
implementation of non-Libor discounting across the front-, middle-, and back-
office operations.
The majority of the respondents who either have fully completed the transition or
are in progress chose a phased implementation, starting with the most affected
business lines and products. The collateralized transactions were chosen first,
while the non-collateralized transactions are still in the planning stage. The
majority of the participants attributed this choice to the fact that an industry-
standard approach to the non-collateralized transactions (both for pricing and
valuations) is still under development.

Other challenges mentioned by participants were as follows.
1. Methodological:
• Basis risk management, gamma and cross gamma computation, and P&L
explanation on certain products.
• Credible overnight indexed swap (OIS) curves to full tenor of
derivative books, so that the OIS/Libor basis risk is hedgeable.
• Portfolio effects for nonlinear CSAs, non-rehypothecation
rights, or tri-party arrangements.
• Clarity on how non-Libor discounting is integrated into non-interest-rate
products (such as long-term OTC equity options).
2. Data and systems:
• Multi-curve capabilities of relevant front-, middle-, and back-office
systems.
• Rolling out the implementation across several systems and across the
organization.
• Using multiple curves to discount assets/liabilities on the same system.
• Linking of collateral data to trading systems.
3. Operational:
• Swaps allocated across different legal entities with different CSAs and
multiple CSA negotiation strategies across legacy companies.
• Dual discounting with inaccurate accounting pressures.
• Funding policy, collateral operations, and collateral options.
• Daily risk and valuation.
All participants agreed that the transition to non-Libor discounting has
also put significant pressure on IT costs and internal resources.
A large majority of respondents in the leading-practitioner pool indicated
that they consider their transition partially completed. They also had a
phased approach to the process whereby the collateralized transactions
were transitioned first. The main reason given was the methodological
uncertainties with pricing the non-collateralized transactions.

Collateralization and Derivatives Pricing and Valuation
The great majority of the institutions that have implemented CSA-based
discounting for their collateralized transactions indicated that this method is
applied mainly to interest-rate products pricing in the front office, followed
by valuation in financial reporting, margining/collateral management, and
risk.
The use of CSA discounting decreases rapidly for other products, led by equity
products and then credit and commodity products.
Participants indicated that, for front-office pricing, the main factors used for
collateralized transactions include CSA collateral terms and conditions,
followed by the Credit Valuation Adjustment (CVA) and hedging and funding
costs. The following CSA terms are the top three used by almost all the
participants for pricing collateralized transactions (in order of decreasing
usage):
• CSA direction (one-way in either direction, or two-way).
• Eligible currencies and securities.
• Thresholds.
The survey produced fairly diverse responses to the question of how the
participants treated transactions with high thresholds and the ones with non-
rehypothecatable collateral. For both cases, the two main responses were:
1) treat as non-collateralized1
and 2) use Libor for discounting. Other
approaches included the use of OIS rates and adjusted cost-of-fund curves.
Less than half the participants indicated they are factoring in the cheapest to
deliver (CTD) optionality in CSAs. Among those institutions factoring in
CTD, the main approach seems to be use of the currency of the trade with a
cross-currency basis with the CTD currency at inception throughout the life of
the trade. Only a very small number of participants use a switch option
approach incorporating volatilities and correlations.
Collateral management is a function that has undergone considerable
enhancements given the transition to CSA-based pricing of collateralized
transactions. The great majority of the participants described the state of data
availability on almost all the CSA terms in their CSA repository as accurate
and reliable. Moreover, a majority of participants have established centralized
collateral management functions in their front-office areas, while half of the
participants that did not establish these functions indicated they plan to do so
in the future. A very small number of these centralized collateral
management functions are operating as profit centers.
1
Note that, for some of the respondents, the treatment of non-collateralized transactions can mean
either Libor-based discounting or cost-of-funds rate-based discounting.

A significant minority of participants also indicated that they have set up a
function in their front- office area to manage the OIS/Libor basis centrally.
Half of the participants that have not yet done so reported that they plan to
have such centralized functions in the future. The survey revealed that this
risk is usually managed by the individual trading desks if no central desk has
been set up.
Responses from the leading-practitioner pool were fairly in line with the rest of
the sample. The responses indicated that, while the majority in this pool uses
Libor discounting for non-rehypothecatable collateral, pricing of transactions
with high thresholds is spread among three main approaches: OIS discounting,
Libor discounting, and a blended curve.
Responses in the pool also revealed that a great majority of leading practitioners
have set up centralized units in their capital markets area for collateral
management, for managing the OIS/Libor, and for other basis risks.
A minority of the leading-practitioner pool also indicated they do price the
cheapest-to-deliver option in. They already do or intend to take this P&L into
the books and record.
Non-collateralized Derivatives Transactions:
Pricing and Valuation
A significant majority of the participants are applying Libor-based
discounting to pricing and valuation of non-collateralized transactions.
Half of the participants who are not using Libor-based discounting indicated
they are using a cost-of-funding curve to price non-collateralized
transactions. The other half of these respondents said they are using OIS
discounting.
The following factors (in order of decreasing usage) were used by the
great majority of participants for front-office pricing of non-
collateralized transactions:
• CVA.
• Funding valuation adjustment (FVA).
• Debt valuation adjustment (DVA).
• Hedging costs, followed by fees and commissions.
Other factors mentioned were liquidity value adjustment and capital.
The survey also revealed that the majority of the participants are planning to
allocate FVAs to legal entities. More than half of the participants are either in
the 1) process of implementing or 2) planning a centralized unit for trading/risk-
managing FVA.

A significant majority of the leading-practitioner pool indicated that they
use Libor discounting for pricing non-collateralized transactions, while the
remaining minority is using cost-of-fund curves for pricing.
The majority of the leading-practitioner pool has either partially
implemented a centralized unit for trading/risk management of FVA, or is
in a planning stage.
The majority of this pool expects that funding costs will be allocated to legal
entities.
Impact of the New Pricing and Valuation on Risk Management
The survey revealed that incorporating non-Libor discounting into the
risk management functions at financial institutions is a work in progress.
A minority of the participants indicated they have the capabilities to manage risks
related to non-Libor discounting in relation to stress testing, Value-at Risk (VaR)/
Potential Future Exposure (PFE), and economic capital calculations. The majority
of institutions do not use non-Libor discounting for counterparty and other types
of risk limit calculations.
The capabilities with incorporating non-Libor discounting (or dual curve
pricing) for risk management purposes lie mainly in the areas of specific
products only (interest rate products).
A majority of respondents indicated they have not yet moved to set risk
limits and hedging capabilities related to new risks arising from the
transition to non-Libor discounting (for example, foreign exchange and
basis risk limits for CVA and equity desks that did not have limits before).
All respondents in the leading-practitioners pool indicated they have
implemented dual curve capabilities in their risk management systems for
interest rate products, for calculating risk sensitivities and VaR. A
significant majority of them have limits management and hedging
capabilities for the new risks established and are reporting on them in
their “Risks Not in VaR” sections, both for the internal and external
reporting.

Survey Addendum on Related
Topics
An addendum to the survey also
presented open-ended questions on how
the Libor-setting irregularities have
affected financial institutions and
whether there is a better alternative to
Libor that the industry should use.
The majority of participants did not have
major concerns about the use of Libor. There
was a shared view among the participants
that Libor would remain a primary bank
lending rate after all the enhancements to its
setting process have been implemented.2
Participants indicated that the alternative to
Libor could be either a more trading-based
index or the OIS rates themselves.
However, some of the participants believe
there is seemingly no other rate with
enough liquidity across all the terms.
Future Surveys
RMA and PwC will build on this survey and
engage in future topical surveys with the
following goals in mind:
• Enhancing the quality of survey
questions (such as refining
questions that might have been
ambiguous or eliminating or
refining questions that proved of
marginal value).
• Improving the quality of the
electronic
survey tool (for example, refining the
process and making it more flexible).
• Solidifying the existing level of
participation and recruiting additional
key institutions.
• Providing an ongoing benchmark in
the areas of valuation, pricing, and
risk management of derivatives
transactions and other functions to
reveal leading practices.
Acknowledgments
This study is the result of an initiative taken
by RMA’s 2012-13 Council on Market
Risk. RMA is grateful to council chair
Murray McIntosh, senior vice president,
Trading Credit Risk, CIBC, for providing
guidance, support, and clarification on
issues related to the survey.
RMA also thanks the PwC staff members
contributing to the study: Jason Boggs, Hovik
Tumasyan, Nassim Daneshzadeh, Justin
Keane, Douglas Summa, and Vuk
Magdalinic. RMA staff members who worked
on the study were Fran Garritt and Stephen
Revucky.
To participate in a future study, please
contact Fran Garritt, Associate Director,
Market Risk and Securities Lending, at
fgarritt@rmahq.org
2. Martin Wheatley, managing director of the U.K. Financial Services Authority, in 2012 proposed a 10-point plan
(the “Wheatley Report”) for reforming Libor and restoring its credibility following the manipulated setting of the
Libor benchmark. Other regulatory and industry working groups are also reviewing the Libor-setting process

About RMA
The Risk Management Association (RMA) is a
not-for-profit, member-driven professional
association serving the financial services industry.
Its sole purpose is to advance the use of sound risk
principles in the financial services industry. RMA
promotes an enterprise approach to risk
management that focuses on credit risk, market
risk, operational risk, securities lending, and
regulatory issues.
Founded in 1914, RMA was originally called the
Robert Morris Associates, named after American
patriot Robert Morris, a signer of the Declaration
of Independence. Morris, the principal financier
of the Revolutionary War, helped establish our
country’s banking system.
Today, RMA has approximately 2,500
institutional members. These include banks of all
sizes as well as nonbank financial institutions.
RMA is proud of the leadership role its member
institutions take in the financial services industry.
Relationship managers, credit officers, risk
managers, and other financial services
professionals in these organizations with
responsibilities related to the risk management
function represent these institutions within RMA.
Known as RMA Associates, these 16,000
individuals are located throughout North America
and financial centers in Europe, Australia, and
Asia.
No part of this publication may be reproduced,
by any technique or process whatsoever,
without the express written permission of the
publisher.
Phone: 800-677-7621
Fax: 215-446-4101
Website: www.rmahq.org
RMA University
In today's rapidly changing financial services
industry, you need practical, day-to-day
knowledge that will help you excel in your
profession. RMA provides quality education
to advance sound risk principles in the
financial services industry. Traditional
classroom training and online learning
resources are available as open enrollments or
as in-bank training. Visit
http://www.rmahq.org/events-training/rma-
university to learn more.
eStatement Studies
RMA’s eStatement StudiesSM
is the only source
of comparative data that comes directly from the
financial statements of small and medium-size
business customers of RMA’s member
institutions. Round-the-clock online access gives
you the ease and flexibility to use this wealth of
information at your convenience. Visit
http://www.rmahq.org/tools-
publications/tools/estatement-studies to learn
more.
Are you an RMA member?
An RMA membership provides many benefits.
In addition to a free subscription to The RMA
Journal® and discounts on RMA events,
products, services, and training, membership
also provides countless networking
opportunities and exposure to the industry's
key decision makers and managers. RMA’s
local and national events keep you up to date
on industry trends and issues while allowing
you to meet new people and swap successes
with peers. Visit http://www.rmahq.org/about-
rma/member-benefits to learn more about
membership.

RMAPWCSurvey_EXE_Summary

Recommended

Recommended

More Related Content

What's hot

What's hot (20)

Similar to RMAPWCSurvey_EXE_Summary

Similar to RMAPWCSurvey_EXE_Summary (20)

RMAPWCSurvey_EXE_Summary