Multi-curve framework: double or quits?

This blog entry is a reaction to the column by Bakkar and Brigo in Risk titled Model risk in the transition to risk-free rates. While I agree with most of the column, there is a secondary issue, which is close to my heart, I would like to react to. And I certainly concur with the last sentence of the column which starts with "This should involve the quant community in an active role" as this has also been my opinion for a long time.

I would nevertheless like to present a different perspective on some side elements of their argument. To my opinion, the expanded use of overnight benchmarks will (should) not reduce the multi-curve complexity.

The pre-2007 single curve "simplicity" was coming from a combination of error and domination. Error in confusing two effects, the (pseudo-)discounting and the reference benchmark. This error was helped by the domination of a rate family: the IBOR benchmarks — the LIBOR king. The crisis emphasised the difference between the overnight benchmark used for collateral remuneration and the IBOR benchmarks and lead to the overnight discounting. A second crisis impact is that the king is dying.

Moving to overnight benchmark as the dominant benchmark may simplify the valuation of vanilla instruments by simplifying the vanilla contracts(1); both the collateral/discounting and the reference benchmark will be the same. But it will only simplify the bank balance sheets on the vanilla derivative side, there is no guarantee that it will simplify the balance sheet globally. The funding term structure of a bank will become the LIBOR of tomorrow but without its liquidity. The generalised VM/IM and its associated costs has pushed the funding issue into the valuation of derivatives (FVA, MVA). There is no need to see the LIBOR or the funding cost to appear directly in the instrument term sheet to need it in derivatives valuation.

I certainly concur with the authors that transition to new benchmark could be an opportunity to review models related to funding but I don't think it will reduce multi-curve complexities. It may lead to a name different from Multi-curve Framework, but the issue of different curves to be used for different purposes will continue to be relevant, maybe even more so with the introduction of new benchmarks. Maybe it will be called the Funding Framework(2).

Even if I concur with the authors that the transition could be an opportunity, I'm afraid that the market will have its back against the wall due to time and regulatory constraints — like in the margin changes case —, that only the minimal to survive will be realistically achieved and that the bank managements, market associations and regulators will not let the quant community play an active role.

Like for other similar issues, I sincerely hope that I will be proved wrong on the quants involvment. Don't hesitate to let me know that I'm wrong, I will enjoy it.

Don't hesitate to contact me for projects on the subject of benchmarks transition.

(1) Contract here as to be understood as a combination of the specific instruments term sheet and the generic master agreement, which govern the now mandatory associated daily variation margin.

(2) By the way, this was the name I used in my March 2007 paper on Discounting Irony, the first paper on what is today called multi-curve framework.

No comments:

Post a Comment