Basel III Framework: The Credit Valuation Adjustment (CVA) Charge for OTC Derivative Trades

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The credit valuation adjustment charge in Basel III appears, at first glance, to be the preserve of quantitative analysts and the like. However, while complex, the CVA charge requires more widespread attention as it materially increases the required capital for OTC derivative trading activities and is driving significant change in that sector. The divergence between the US and EU approaches to the adoption of the CVA charge highlights how the Basel standards have been interpreted differently in this important area, creating uncertainty and opportunities for arbitrage.

Two-thirds of counterparty credit losses in the financial crisis were suffered not as a result of actual defaults of the counterparty, but because credit market volatility negatively impacted bank earnings. In response, the Basel Committee on Banking Supervision (“Basel Committee”) introduced a new capital charge in Basel III, the credit valuation adjustment (the “CVA”) charge, aimed at improving banks’ resilience against potential mark-to-market losses associated with deterioration in the creditworthiness of counterparties to non-cleared derivatives trades. The CVA charge applies to non-cleared trades as exposures toward central counterparties (“CCP”) are exempt from the CVA charge.

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