The New Economics of OTC Derivatives: MVA vs. CVA, FVA & KVA
The impact of Initial Margin – Part 1
From September 2016 the financial industry is facing new regulation that is going to shape (again) the business of OTC derivatives: all tier-1 derivative dealers will have to post Initial Margin on their books of bilateral trades. From September 2020 nearly all financial institutions will have to comply. The Fed and ISDA have estimated the cost of this new framework in the many-billion zone.
In this first part of this paper we introduce the details of the new regulatory framework and present computations of all XVAs (including MVA) under different trading conditions for an illustrative interest rate swap. We see how the cost of trading is going back to the old uncollateralised levels with the new regulation. We also show how banks now have a clear economic incentive to clear trades via CCPs, but also that there will still be a strong market for bilateral trading. We see how MVA can have strong Wrong Way Risk and how not only the actual value of MVA will be very high but its volatility will be very strong too in stressed markets as a result of the leverage mechanism that the regulatory €50m threshold produces. Therefore, simulating the Initial Margin accurately within the XVA Monte Carlo engine is central for correct pricing and hedging.