Challenges Facing the South African Derivatives Market
by Bianca Ruddy and Simona Nicole Levet, Financial Risk Management Team, KPMG Advisory
The unrelenting waves of regulatory reforms that have followed in the wake of the 2008-09 crises are creating tectonic shifts across the derivatives landscape. The South African derivatives market is far from immune. Among the swathe of regulations is Basel III, while – as a member of the G20 – South Africa will also start to address OTC derivatives reform through the framework of the Financial Markets Act. At the intersection of these regulatory reforms is the desire for greater transparency and more secure derivatives trading, to buffer and safeguard financial markets against another meltdown.
These reforms have, however, introduced a significant degree of complexity. They will change the way that derivatives are priced, traded and reported. With so many of the operational details still in evolution, there is much uncertainty among market participants. Beyond the banks, a broad range of market participants will feel the impact: from corporates hedging their FX and interest rate exposures, to insurance companies hedging their long-dated liabilities, and from hedge funds and asset managers executing a variety of strategies, to pension funds focusing on long-dated funds. Business models, operations and infrastructure will have to adapt and evolve, balancing the imminent and urgent against the longer-term strategy and available resources.
The unintended consequences introduced by the ‘new paradigm’ will be revealed in time. For now, KPMG sought to unlock the perspectives of South African derivatives market participants around these challenges, gaining insight through a survey and discussions.
When the tide goes out...
On 15 September 2008, Lehman Brothers filed its bankruptcy petition. The default exposed the lack of transparency around the credit worthiness of derivative market players, the exposure size – not to mention who was ultimately exposed, and spotlighted issues relating to collateral management.
Now, a number of the changes facing the world of listed and over-the-counter (OTC) derivatives relate to managing and mitigating counterparty credit risk. Counterparty credit risk is the risk that the counterparty to a non-exchange-traded contract defaults prior to expiration. It differs from conventional credit risk in the fact that (1) exposure at the time of default is uncertain as it depends on future market dynamics and (2) the risk is generally bilateral, as either party may end up owing money to the other.
Credit Valuation Adjustment, the conceptually simple, yet operationally challenging, metric that emerged as an accounting stipulation in 2000, is attracting attention – and debate – as a result of the inclusion of a CVA VaR capital requirement in Basel III. The decision to include an explicit capital requirement stems from the observation by the Bank of International Settlements (BIS) that nearly two thirds of losses that banks suffered during the credit crisis emanated from un-hedged CVA volatility, whereas only one third could be directly attributed to actual default. CVA will capture potential mark-to- market changes related to fluctuations in the credit quality of a bank’s counterparties.
South Africa has been awarded a stay of execution – the SARB directive D3/2012 permits a zero risk weight for CVA on ZAR-based derivatives and derivatives with local counterparties for 2013, pending the finalisation of a centralised counterparty for over-the-counter (OTC) derivatives in South Africa. However, banks agree that it is not just about meeting a regulatory requirement – the rationale behind quantifying and managing CVA is prudent risk management practice.
While the degree of implementation varies, the end game is a centralised group, the CVA desk, whether this involves leveraging vendor solutions or offshore capabilities. Given the degree of counterparty concentration, as well as the lack of CDS contract coverage, respondents have generally adopted a pragmatic approach to managing CVA. Banks have tended to focus initially on those counterparties and transactions which are the largest drivers of the CVA charge. Considering the relative size of the interest rate and FX derivatives markets, it is not surprising that implementation efforts are focused on these asset classes.
Addressing whether CVA charges are uniformly included in pricing, buy-side survey respondents have observed pricing differences that they attribute to the introduction of CVA in pricing, sourced across all banks operating in the South African market. Feedback suggests that CVA may, however, be excluded for particular transactions for relationship reasons, in instances where there is cross-subsidisation from other areas of the business, or where banks deem that collateral agreements are sufficiently robust.