Client Engineering of XVA in Crisis and Normality: Restructuring, Mandatory Breaks and Resets

Abstract

Crises challenge client XVA management because the prices of derivatives contain the XVA hedges that the provider requires, as well as the functional hedge the client requires. By functional hedge we mean the hedge linked to the client's business, e.g. FX, inflation, interest rate. By XVA hedge we mean the hedge linked to the client's credit risk and the provider's funding risk. The issue is that a derivative locks in the client credit level and the provider's funding level on the trade date, for the life of the trade. During a crisis both levels may be elevated. The standard methods for separating XVA hedges from the functional hedge is to use a Mandatory Break at inception, limiting the lock in, or to restructure post-trade assuming XVA can be rebated. Alternatively, in normal times resets can be used and are better because the client pays XVA on the continuation after the reset using the provider's view of client survival probability from original trade inception. We quantify these strategies from the client point of view to find where a Mandatory Break, or equivalently restructuring, is a better client strategy and where a reset is better. This quantification combines risk-neutral and risk-neutral conditional on physical measures. We provide numerical examples using Mandatory Breaks/restructuring and resets, informed by credit shocks and recovery from past crises. In normal times a reset can be twice as effective as a Mandatory Break or restructuring, whereas provided there is at least a 1/3 recovery from a CDS shock a Mandatory Break is better in our examples.

Keywords: XVA, credit, funding, crisis, mandatory break, reset, restructuring, hedging, client valuation, Covid-19

JEL Classification: G13, G11, G14, G12, G21, G23, C61, G01, G32, G35, I10