Closeout

Abstract: In this paper we focus on a fundamental practical issue regarding the bilateral counterparty risk adjustment. The past literature assumes that, at the moment of the first default, a risk-free closeout amount will be used. The closeout amount is the net present value of the residual deal which is computed when one party defaults, and that is used for default settlement. A risk-free closeout amount assumes that the surviving counterparty is default-free. We argue that the legal (ISDA) documentation suggests in many points that a substitution closeout should be used. This would take into account the risk of default of the survived party. The bilateral counterparty risk adjustment changes strongly when a substitution closeout amount is considered, as we show. We believe financial practitioners should be aware of this. We also show the effects of the two different closeout conventions in terms of default contagion. If a substitution closeout will be used, as suggested in the ISDA documentation, there will be a lower recovery for creditors, an unpleasant fact that is particularly clear when the defaulted entity has high systemic relevance and therefore is highly correlated with its counterparties. On the other hand, if a risk-free closeout will be used, as suggested in the past literature, there will be at default unexpected losses that affect also the debtors of the defaulted entity, not only the creditors as usually expected. This additional contagion towards debtors is at odds with standard counterparty risk for bonds or loans, and will be stronger the higher is the credit risk of the debtors. These results should be considered carefully by the financial community. In the end, we analyze the effect of the two different closeouts for collateralized derivatives.

Abstract: In the absence of a universally accepted procedure for the credit valuation adjustment (CVA) calculation, we compare a number of different bilateral counterparty valuation adjustment (BVA) formulas. First we investigate the impact of the choice of the closeout convention used in the formulas. Important consequences on default contagion manifest themselves in a rather different way depending on which closeout formulation is used (risk-free or replacement), and on default dependence between the two entities in the deal. Second we compare the full bilateral formula with an approximation that is based on subtracting two unilateral credit valuation adjustment (UCVA) formulas. Although the latter might be attractive for its instantaneous implementation once one has a unilateral CVA system, it ignores the impact of the first-to-default time, when closeout procedures are ignited. We illustrate in a number of realistic cases both the contagion effect due to the closeout convention, and the CVA pricing error due to ignoring the first-to-default time.

Abstract: Closeout procedures enable central counterparties (CCPs) to respond to events that challenge the continuity of their normal operations, most frequently triggered by the default of one or more clearing members. The procedures ensure the regularity of the settlement process through the prudent and orderly closeout of the defaulter’s portfolio. Traditional approaches to CCPs’ margin requirements typically assume a simple closeout profile, and do not account for the ‘real-life’ constraints embedded on the management of a default. The paper proposes an approach of evaluating how distinct closeout strategies may expose a CCP to different sets of risk and costs, and consequently could impact the sufficiency of financial resources to cover its risk exposure to a default. The approach is based on a counterfactual simulation, and evaluates a full spectrum of hedging strategies in an exploratory and model-free manner, deriving endogenous and market-dependent risk metrics. Using the trade repository data available to the Bank (as a result of EMIR reporting) on over-the-counter (OTC) interest rate swaps (IRS) and ten years (ie 2005 to 2015) of information on related market risk factors, the paper derives empirically an efficient hedging strategy that minimizes the CCP’s risk exposure to a defaulting clearing member. Endogenous trade-off structures between total risk (market risk plus funding needs) and transaction costs are also established, with marginal sensitivities to individual components of the hedging strategy determined.