This paper will explore some of the key changes to internal counterparty risk management processes by tracing typical workflows within banks before and after CVA desks, and how increased clearing due to regulatory mandates, affects these workflows. Since CVA pricing and counterparty risk management workflows require extensive amounts of data, as well as a scalable, high-performance technology, it is important to understand the data management and analytical challenges involved. • Current trends and best practices • Key data and technology challenges

1. WHITE PAPER
HoW THE CREdIT CRIsIs HAs CHAngEd
CounTERPARTy RIsK mAnAgEmEnT
Authored by David Kelly (Quantifi)
• Current trends and best practices
• Key data and technology challenges
www.quantifisolutions.com

2. ABout the Author
David Kelly
david Kelly, director of Credit Products, Quantifi, brings almost 20
years of experience as a trader, quant, and technologist to Quantifi.
He has previously held senior positions at some of the largest financial
institutions including Citigroup, JPmorgan Chase, AIg and CsFB.
At Citigroup, he was the senior credit trader on the global Portfolio
optimisation desk, responsible for actively managing the credit risk in
derivatives positions. Prior to this, he ran the JPmorgan Chase global
Analytics group, where he was responsible for front-office pricing models
and risk management tools for the global derivatives trading desks
including the firm’s first CVA system. An enrolled member of the society of Actuaries, mr.Kelly
holds a B.A. in economics and mathematics from Colgate university and has completed graduate
work in mathematics at Columbia university and Carnegie mellon.

3. IntroDuctIon
The credit crisis and regulatory CVA desks have
responses have forced banks to
substantially update their counterparty been developed in
risk management processes. response to crisis-driven
new regulations in the form of Basel III, the regulations for improved
dodd-Frank Act in the u.s. and European
market Infrastructure Regulation (EmIR) have counterparty risk
dramatically increased capital requirements
for counterparty credit risk. In addition to
management. How do
implementing new regulatory requirements,
banks are making significant changes to internal
these centralized groups
counterparty risk management practices. differ from traditional
There are three main themes inherent in these approaches to manage
changes. First, better firm-wide consolidated risk
reporting has become a top priority. second, counterparty risk, and
centralized counterparty risk management
groups (CVA desks) are being created to more
what types of data and
actively monitor and hedge credit risk. Third,
banks are making significant investments in
analytical challenges do
technology to better support the firm-wide risk they face?
reporting and CVA desk initiatives.
This paper will explore some of the key changes
to internal counterparty risk management
processes by tracing typical workflows within
banks before and after CVA desks, and how
increased clearing due to regulatory mandates,
affects these workflows. since CVA pricing and
counterparty risk management workflows require
extensive amounts of data, as well as a scalable,
high-performance technology, it is important to
understand the data management and analytical
challenges involved.

4. Before cVA DesKs
CVA desks or specialized risk control charges are based on an internal qualitative and
quantitative assessment of the credit quality of
groups tasked with more actively
the counterparty by the bank’s credit officers.
managing counterparty risk are
becoming more prevalent, since banks The credit portion of the charge is for the
that had them generally fared better expected loss, i.e., the cost of doing business
with risky counterparties. It is analogous to CVA,
during the crisis. except that the CVA is based on market implied
inputs, including credit spreads, instead of
To establish a basis for comparison, it is
historical loss norms and qualitative analysis.
important to review counterparty credit risk
pricing and post-trade risk management before The capital portion is for the potential unexpected
the advent of CVA desks. The case where a loss. This is also referred to as ‘economic capital’,
corporate end-user hedges a business risk which traditionally has been based on historical
through a derivative transaction provides a experience but is increasingly being calculated
useful example. with market implied inputs. These charges go into
a reserve fund used to reimburse trading desks for
The corporate treasurer may want to hedge counterparty credit losses and generally ensure
receivables in a foreign currency or lock in the the solvency of the bank.
forward price of a commodity input. Another
common transaction is an interest rate swap The trader on the desk works with the risk
used to convert fixed rate bonds issued by the control group, which may deny the transaction
corporation into floaters to mitigate interest if the exposure limit with that particular
“Banks are making significant investment in technology
to better support the firmwide risk reporting an
CVA desk initiatives.”
rate risk. In all of these cases, the corporate counterparty is hit. otherwise, it provides the
treasurer explains the hedging objective to the credit and capital charges directly or the tools
bank’s derivatives salesperson, who structures to allow the trader to calculate them. The risk
an appropriate transaction. The salesperson control group also provides exposure reports
requests a price for the transaction from and required capital metrics to the bank’s
the relevant trading desk, which provides a regulator, which approves the capital calculation
competitive market price with ‘credit’ and methodology, audits its risk management
‘capital’ add-ons to cover the potential loss processes and monitors its ongoing exposure and
if the counterparty were to default prior to capital reserves according to the Basel guidelines.
maturity of the contract. The credit and capital

5. While counterparty risk is managed through “To establish a basis for
reserves in this example, the market risk of
the transaction is fully hedged by the desk comparison, it is important
on exchanges or with other dealers. If the
transaction is uncollateralized, the bank’s
to review counterparty credit
treasury provides funding for what is effectively risk pricing and post-trade
a loan to the customer in the form of a derivative
line of credit. some portion of the exposure risk management before the
may also be collateralized, in which case there
are additional operational workflows around
advent of CVA desks.”
collateral management.
counterPArty rIsK WorKfloW Before cVA DesKs
Corporate Treasury
Derivatives Transaction
Bank Derivative Sales
Derivatives Pricing
Bank Treasury (funding) Funding Derivatives Trading Desk Market Exchanges & Dealers
Risk
Credit & Capital
Reserves
Collateral Collateral
Management Risk Risk Control
Regulatory Capital
& Reporting
Bank Regulator

6. cVA DesKs
one of the drivers for CVA desks was default swap (CCds). The CVA charge is passed
on to the external corporate customer by adding
the need to reduce credit risk, i.e., free
a spread to the receive leg of the trade. unless
capacity and release reserves, so banks the CVA is fully hedged, which is unlikely, the
could do more business. spread charged to the customer should also
include some portion of economic capital to
In the late 1990’s and early 2000’s, in the wake of account for CVA VaR and potential unexpected
the Asian financial crisis, banks found themselves loss from default.
near capacity and were looking for ways to
reduce counterparty risk. some banks attempted since credit risk spans virtually all asset classes,
to securitize and re-distribute it, as in JPmorgan’s the CVA desk may deal with multiple internal
Bistro transaction. Another approach was to trading desks. The risk control group treats the
hedge counterparty risk using the relatively new CVA desk like other trading desks, imposing
Cds market. trading limits and monitoring market risks using
traditional sensitivity metrics and VaR. The CVA
The recent international (2005) and u.s. (2007) desk executes credit and market risk hedges on
accounting rules mandating the inclusion of CVA exchanges or with other dealers and relies on the
in the mark-to-market valuations of derivatives bank’s internal treasury to fund positions. To the
positions provided additional impetus for more extent the CVA desk attempts to fully replicate
precisely quantifying counterparty risk. some (hedge) CVA, while the derivatives desks also
banks attempted to actively manage counterparty hedge the underlying market risks, there may be
risk like market risk, hedging all the underlying some inefficiencies due to overlapping hedges.
risk factors of the CVA. given the complexity of
CVA pricing and hedging, these responsibilities The key innovation introduced by CVA desks is
have increasingly been consolidated within quantifying and managing counterparty credit
specialized CVA desks. now, with the increased risk like other market risks, instead of relying
capital charges for counterparty default risk under solely on reserves. The main challenge is that not
Basel III and the new CVA VaR charges, there is all CVA risk can be hedged due to insufficient
even more incentive to implement CVA desks. Cds liquidity and unhedgeable correlation and
basis risks. Therefore, some reserve-based risk
With a CVA desk, most of the trading workflow management is unavoidable. Based on trends
is the same except the CVA desk is inserted among the top-tier banks, the optimal solution
between the derivatives trading desks and the involves hedging as much of the risk as possible,
risk control group. Instead of going to the risk considering the cost of rebalancing hedges in
control group for the credit and capital charges, a highly competitive CVA pricing context, and
the trader requests a marginal CVA price from then relying on experienced traders well-versed
the CVA desk, which basically amounts to the in structured credit problems to manage the
CVA desk selling credit protection on that residual exposures.
counterparty to the derivatives desk. This is an
internal transaction between the two desks,
which can be in the form of a contingent credit

7. “With the increased capital charges for counterparty
default risk under Basel lll and the new CVA VaR charges,
there is even more incentive to implement CVA desks.”
counterPArty rIsK WorKfloW WIth cVA DesK
Corporate Treasury
Derivatives Transaction
Bank Derivative Sales
Derivative Pricing
Bank Treasury (funding) Funding Derivatives Trading Desk Market Exchanges & Dealers
Risk
Marginal CVA Price
Funding CVA Desk Credit Risk
Exposure Limits
Collateral Collateral
Risk Risk Control
Management
Regulatory Capital
& Reporting
Bank Regulator

8. cleArIng
The predominant issues with CVA not all trades can or will be cleared.
Clearinghouses will only be able to handle
desks are that they insert another
standardized contracts and the dodd-Frank and
operational layer into the workflow and EmIR regulations specifically exempt corporate
add substantial analytical complexity. end-user hedge transactions from mandatory
clearing, so that banks can continue to provide
CVA models have to incorporate all the market credit lines and risk transfer services through
risk factors of the underlying derivative plus derivatives. It is estimated that at least a quarter
the counterparty credit risk. Even the CVA on a of derivatives transactions will remain oTC,
plain vanilla FX forward is complex because the which means banks will need to maintain both
counterparty effectively holds an American-style CVA and clearing workflows.
option to default. In addition to the option risk
profile, the CVA trader must also consider the
correlation between the counterparty’s default “Transactions are assigned
probability and the underlying market risk
factors, i.e., ‘wrong-way risk’. or novated to the
margining formulas are much simpler than
clearinghouse, which
CVA and economic capital models, and new becomes the counterparty
regulations are either mandating or heavily
incentivizing banks to clear or fully collateralize
to both sides of the trade.”
derivative transactions. In cleared transactions,
the clearinghouse effectively replaces the CVA
desk in the workflow. Transactions are assigned
or novated to the clearinghouse, which becomes
the counterparty to both sides of the trade.
Counterparty risk is virtually eliminated because
the exposure is fully collateralized and ultimately
backed by the clearinghouse and its members.
There is a remote risk that the clearinghouse fails
but the risk control group can focus on relatively
simpler issues like collateral management,
liquidity, and residual market risks. since cleared
transactions are fully margined, the CVA charge is
replaced by the collateral funding cost, which is
typically based on an overnight rate.

9. “Counterparty risk is virtually eliminated because
the exposure is fully collateralized and ultimately backed
by the clearinghouse and its members.”
counterPArty rIsK WorKfloW WIth cleArIng
Corporate Treasury
Derivatives Transaction
Bank Derivative Sales
Derivatives Pricing
Bank Treasury (funding) Funding Derivatives Trading Desk Market Exchanges & Dealers
Risk
Collateral Funding
Cost
Collateral Funding Credit Clearinghouses
Management Risk Control Risk
Regulatory Capital
& Reporting
Bank Regulator

10. DAtA AnD technology chAllenges
Reliable data feeds that facilitate crisis, such as wrong-way risk. Regulators are
continuously raising the bar in terms of modeling
regular updates and data
every risk factor, such as potential shifts in
integrity checks are absolutely basis spreads, volatilities and correlations. new
fundamental to effective regulatory requirements for back-testing and
counterparty risk management. stress testing are designed to ensure the validity
of the model.
Banks typically maintain separate systems for
their main trading desks, roughly aligned by the outputs of the simulation engine include current,
major asset classes – interest rates and foreign expected and potential future exposures,
exchange, credit, commodities and equities. CVA and economic capital by counterparty.
since counterparty risk spans all asset classes, The system should also capture counterparty
the counterparty risk system must extract exposure limits and highlight breaches. given the
transactions, market data and reference data complexity of the inputs and outputs, a robust
from all the various trading systems. In addition, reporting system is critical. The system should
supplemental reference data on legal entities allow aggregation of exposure metrics along a
“The most sophisticated global banks have targeted
the CVA and clearing workflows and supporting technology
infrastructure. It is expected that regional banks will
follow suit over the next few years.”
and master agreements may need to come from variety of dimensions, including industry and
other databases. These systems typically use legal jurisdiction. The system should also allow
different data formats, symbologies and naming drilling down into results by counterparty netting
conventions, as well as proprietary interfaces, set and individual transactions. By extension,
adding significant complexity. users should have an efficient means to diagnose
unexpected results.
The next set of challenges involves balancing
performance and scalability with analytical There may also be a separate system for marginal
robustness. The simulation engine may have to pricing of new trades and active management of
value on the order of one million transactions CVA. The marginal pricing tools need to access
over a hundred future dates and several thousand results of the portfolio simulation, since the price
market scenarios. depending on the size of of each new trade is a function of the aggregate
the portfolio and number of risk factors, some exposure with that counterparty. Because of
shortcuts on the modeling side may be necessary. this, calculating marginal CVA in a reasonable
However, there are critical analytical aspects that time frame can be a significant challenge. The
cannot be assumed away given their role in the CVA risk management system provides CVA

11. sensitivities for hedging purposes. Hedges the simulation engine would upload current
booked by the CVA desk should flow through collateral positions and revalue them for each
the simulation engine so that they are reflected market scenario to determine net exposure. The
in the exposure and capital metrics. Whereas the simulation engine should also incorporate the
CVA desk may hedge credit and market risks, ‘margin period of risk’, i.e., the risk of losses from
only approved credit hedges, including Cds, non-delivery of collateral.
CCds and to some extent credit indices, may be
included for regulatory capital calculations. Even with the crisis-induced wave of
improvements, the picture remains very complex.
Cleared transactions must be fed to the The most sophisticated global banks have
clearinghouses’ systems and trade repositories. targeted the CVA and clearing workflows and
since clearing involves daily (or more frequent) supporting technology infrastructure described
margining, the bank’s collateral management in this paper. It is expected that regional banks
system should be integrated with the will follow suit over the next few years in order to
clearinghouse. It should also be integrated optimize capital and manage risk more effectively,
with the counterparty risk system. Ideally, as well as comply with new regulations.
counterPArty rIsK DAtA floWs & technology InfrAstructure
IR/FX Credit Commodities Equities
Trading System(s)
• Counterparties • Transaction
• Legal Limits • Reference Data • Market Data
Clearing Systems
& Trade Repos
CVA Risk Counterparty Exposure Collateral
Management System Simulation Engine Management System
Marginal CVA Pricing Tool Reporting

12. ABouT QuAnTIFI
Quantifi is a leading provider of analytics, trading and risk management software for the
global oTC markets. our suite of integrated pre and post-trade solutions allow market
participants to better value, trade and risk manage their exposures and respond more
effectively to changing market conditions.
Founded in 2002, Quantifi has over 120 top-tier clients including five of the six largest global
banks, two of the three largest asset managers, leading hedge funds, insurance companies,
pension funds and other financial institutions across 15 countries.
Renowned for our client focus, depth of experience and commitment to innovation, Quantifi is
consistently first-to-market with intuitive, award-winning solutions.
For further information, please visit www.quantifisolutions.com
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