Under the current banking regulations, banks are subject to a capital charge primarily to cover the losses arising from the actual default of a counterparty of an over-the-counter ('OTC') derivative contract. Under the proposed Basel III framework, the capital charge will be enhanced by a new charge, called the Credit Valuation Adjustment ('CVA') Risk Capital Charge. This is a capital charge, whereby the bank is required to hold additional capital when entering an OTC trade. The charge is designed to cover losses arising from the fact that as the counterparty's financial position worsens, the market value of its derivatives obligation declines, even though there might not necessarily be an actual default. The charge incentives hedging, a failure of the Basel II standards observed during the 2008 financial crisis, as well as encouraging market participants to use central clearing.The CVA may be largely passed on to end users via higher transaction costs.The impact of this charge is that it will potentially have an impact on the performance of the portfolio and the implementation date is 1 January 2014 for ZAR denominated trades. Two ways to mitigate CVA and minimize the impact on your portfolio is through: o Collateralisation o Central clearing To find out how you can create a collateral management program, join us for our practical Collateral Management course in Johannesburg on 15-16th August 2013. For more information: Visit:www.hedgefudacademy.co.za

1. For further discussion or information about the coverage of CVA at our 5 – 6 August 2013 conference, please call Yvonne van Wyk or
Marilyn Ramplin on 011 783 9390 or email yvonne@hedgefundacademy.co.za. Vat No: 4560 261 069
CVA due date Jan 2014 - Implication for Hedge Funds,
Corporates, Asset Managers and Pension Funds
Credit Valuation Adjustment
Under the current Basel II standards, banks are subject to a capital
charge primarily to cover the losses arising from the actual default
of a counterparty of an over-the-counter (‘OTC’) derivative
contract.
Under the proposed Basel III framework, the capital charge will be
enhanced by a new charge, called the Credit Valuation
Adjustment (‘CVA’) Risk Capital Charge. This is a capital charge,
whereby the bank is required to hold additional capital when
entering an OTC trade. The charge is designed to cover losses
arising from the fact that as the counterparty’s financial position
worsens, the market value of its derivatives obligation declines1,
even though there might not necessarily be an actual default. The
charge incentivises hedging, a failure of the Basel II standards
observed during the 2008 financial crisis, as well as encouraging
market participants to use central clearing.
As currently drafted, the CVA risk capital charge when using
OTC derivatives will be greater for trades with any of the
following characteristics:
1. Long dated derivatives: CVA considers the entire life of the
derivatives exposure.
2. Directional risk profiles: CVA is based on the net exposure to a
given counterparty.
3. Uncollateralized exposures: An input to the CVA calculation is
the size of the expected uncollateralized mark to market values.
Posting daily collateral reduces the charge substantially.
4. Low rated counterparties: Higher probability of default results in
a higher CVA charge.
5. Counterparties with no liquid CDS market: A capital charge
reduction is allowed where counterparty exposure is reduced
through the use of a CDS contract.
Introduction
The South African Reserve
Bank (SARB) will implement
the proposed Basel III
standards on capital and
liquidity for all banks in SA.
The Basel III rules seek to raise
both the quality and quantity
of the regulatory capital base
and incentivise clearing
through higher capital
requirements on un-cleared
positions.
Although the capital
requirements do not apply
directly to hedge funds,
pension plans and
investments managers, the
increased cost imposed on
investment banks for their
derivatives business is likely to
be, at least in part, passed on
to end users through higher
transaction costs.
Given this list of
characteristics, it is clear
that the typical trades
that are transacted by
hedge funds, pension
funds and asset
managers may attract
particularly large CVA
risk capital charges.
Most fixed income funds
are already experiencing
the impact of CVA.

2. For further discussion or information about the coverage of CVA at our 5 – 6 August 2013 conference, please call Yvonne van Wyk or
Marilyn Ramplin on 011 783 9390 or email yvonne@hedgefundacademy.co.za. Vat No: 4560 261 069
How to mitigate the CVA charge:
 Collateralisation
 Central clearing
Collateralisation
Collateral where the threshold is zero and low minimum
transfer amounts will have better treatment, but collateral
does not eliminate all counterparty risk and therefore the
CVA charge will not disappear. Many firms are under
pressure from their banking counterparts to collateralise their
trades. The process of collateralisation is new to many
buyside institutions and has left many firms with severe
challenges around legal, fund structure, regulatory,
operational, risk and liquidity issues. The impact of CVA is,
however, real for a number of managers and will impact the
performance of their portfolio.
Central Clearing
Clearing is a post-execution process in which an
independent third party – central clearing counterparty
(“CCP”) or clearing house – steps in between the original
parties to a derivatives transaction and guarantees the
performance of both parties. The clearing house “becomes
the buyer to every seller and the seller to every buyer”,
through a process known as “novation”.
Trades that are cleared through a central counterparty
(‘CCP’) will be collateralized daily, reducing any potential
CVA charge. In a centrally cleared model, counterparty risk
is reduced by each end investor facing a clearing member,
and in turn the member faces the CCP. The exposure that
the clearing member has to the client is identical to the
exposure it has to the CCP, effectively passing through’ the
client’s counterparty risk to the CCP.
Counterparties who previously did not have to post
collateral (variation or independent amount) will now have
to post collateral. The CCP does not distinguish between the
risk of the counterparties, but calculates margin based on
the risk of the product. This could result in liquidity concerns
for some funds where this has not been managed properly
or the fund is new to posting collateral.
In SA we don’t currently have a CCP, but the Financial
Markets Act makes provision for the creation of a CCP.
Costs
The CVA charge is levied directly in relation to an
investment bank’s balance sheet and it is expected
that at least some (if not all) of this cost will be passed
on to end investors. Due to the fact that the charge is
levied on a net basis, it is difficult to estimate the
impact of an additional trade without prior knowledge
of the risks already on the balance sheet.
When a trade is added to the balance sheet of the
bank, a capital provision will be made, effectively
‘locking up’ this amount of capital. The charge that
could be passed on to the fund (in the form of
increased transaction cost) will be related to the
‘opportunity cost’ of that inactive capital; the size of
Summary
 The combination of Basel III and SA
G20 commitments seeks to implement
the regulation to create an efficient
and safe derivatives market.
 Basel III brings new rules in four areas
o capital quality
o capital requirements
o leverage ratios
o liquidity ratios
 The impact of the Lehman Brothers
collapse was also seen as another
driving force behind reform.
 The effect on banks will be to
increase the capital they have to
keep as a provision for the
deterioration of the credit worthiness
of trading counterparties.
 The charge that is levied, the Credit
Valuation Adjustment (CVA) Risk
Capital Charge, may be largely
passed on to end users via higher
transaction costs. The impact of this
charge is that it will potentially have an
impact on the performance of the
portfolio.
 In general these costs will probably be
higher for bilateral, long-dated,
uncollateralized derivatives.
 The SARB has pushed out the
implementation date for ZAR
denominated trades to end of Dec 2013

3. For further discussion or information about the coverage of CVA at our 5 – 6 August 2013 conference, please call Yvonne van Wyk or
Marilyn Ramplin on 011 783 9390 or email yvonne@hedgefundacademy.co.za. Vat No: 4560 261 069
the provision and the bank’s target return on capital.
How we can help:
Advisory service
We offer an advisory service to help you structure you collateral agreements with your counterparties and implement
a collateral management framework to reduce your CVA charge.
Training
The Hedge Fund Academy runs regular in-house and bespoke courses on Collateral Management, CCP and
Regulations. For more details visit www.hedgefundacademy.co.za
Contact : Marilyn Ramplin
Tel: 011 783 9390 marilyn@hedgefundacademyco.za
•An additional risk based capital charge (‘CVA’) for non-centrally
cleared/bilateral trades - capital charge is intended to cover risk
associated with the deterioration in the creditworthiness of a
counterparty
What is changing?
•An additional capital charge will make bilateral derivative trading
more capital intensive for banks. The impact on capital
requirements will be greater for exposures that are:
uncollateralized, with low rated counterparties, long maturity and
directional. Bilateral derivative trades will require counterparties
to post variation margin and may require counterparties to post
initial margin.
Comments
•Some of all this cost incurred by banks is likely to be passed on to
hedge funds, pension funds, corporates and asset managers.
•Potentially significantly impact funds with long-dates interest rate
and inflation exposures or funds in the LDI space.
•Bilateral derivative trades will be more capital intensive than they
are today and could affect the performance of your funds.
How it may impact you
•Collateral Management with the correct parameters to reduce
counterparty risk
•CCP which would eliminate counterparty risk and therefore the
charge, but currently we don't have a CCP for OTC derivatives.
Ways to reduce your CVA
•The planned implementation date for CVA for ZAR denominated
trades is January 1, 2014.
Timeline