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Accounting for OTC Derivatives: Funding Adjustments and the Re-Hypothecation Option

Updated: Jul 8, 2021

Published: August 2014

The ability to process over a billion paths opens the door to proper modelling of re-hypothecated collateral and, with aggregation to legal entity, accurate FVA calculation.

Banks hold and routinely exercise the option of freely re-hypothecating variation margin across counterparties and trades. However, the emerging FCA/FBA standards for funding cost accounting are mostly formulated in terms of netting set specific metrics that fail to properly account for re-hypothecation benefits to Common Equity Tier 1 Equity Capital (CET1). Additionally, the FCA/FBA standard introduces a double-counting issue between funding benefits and DVA which ultimately leads to a violation of the fundamental accounting tenet of asset-liability symmetry.

In this paper, we propose an alternative accounting framework meant to rectify some of the problems in existing standards. The new accounting method, denoted FVA/FDA, explicitly incorporates the re-hypothecation option into its definition of funding costs, and maintains consistency with the Modigliani-Miller Theorem, with fair-value asset-liability symmetry and with Basel III rules for DVA and equity capital. We argue that derivative pricing necessitates an incremental assessment of the capital structure impact of new trades and propose that entry prices should be struck at the indifference level for CET1. Unlike the FCA/FBA method, FVA/FDA accounting does not result in outright net income write-offs due to funding costs.

FCA/FBA accounting and FVA/FDA accounting lead to very similar and quantitatively close conclusions in the particular case of a portfolio consisting of a single netting set and a single trade. However, material differences arise in the case of large portfolios. We discuss a case study with a representative portfolio whereby CET1 adjustments for funding are three times as large as the ones required in FVA/FDA accounting. In case portfolio effects are accounted for, incremental entry prices for individual trades differ materially between the FCA/FBA and the FVA/FDA methods, with FCA/FBA accounting often displaying sizable and risky pricing biases between derivative payables and receivables.

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