What is the role of Credit Valuation Adjustment (CVA) desks in investment banks?

  • What does a CVA (Credit Valuation Adjustment) desk do, and how are its activities different from other trading desks? Can you work as a quant for a CVA desk and consider your role "front office"?

    For those not in the know, what is the acronym CVA? :)

    To value CVA/DVA correctly, you need to take wrong way risk into account. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2267508

  • CVA desks are not front office as they have no dealings with external clients. They can be considered "smart middle office" as they are a necessary part of the plumbing to facilitate the core activity of the bank, which is to trade as many derivatives as possible with clients, all of whom have varying levels of credit risk. Essentially, it allows traders in financial products to specialise in their area, rather than having to worry about overlaying credit on top of their pureplay core competence.

    My personal experience is that good CVA people often make it to the front office, and are certainly part of the dealmaking process as there will often be a negotiation with them to take on a credit risk (at the right price) which will make/break an external transaction.

    To the extent that you "deal" with internal clients you can be said to have "front office style" skills, but remember, most trading desks must deal with you, whereas most external clients do not have to deal with the bank. That's the key difference. There's no art in transacting with captive clients.

    Of course, CVA is super complex as you have massive correlations to worry about on risks right across the bank, many (most) of which are unhedgable directly, and so the quants on these desks usually are highly respected, and must have a strong feel for the market as there will always be risks that they want to (or indeed have to) keep. So they're often great traders. That said, a large part of their profits will be used up as reserve, so they won't get paid on it, that reserve will often vanish in a crisis, and finally, if a CVA desk is making "too much" money (obviously hard to define - but easy to point fingers at), they will attract the attention of the management, for the wrong reasons, because ultimately, to the people that run the show, they represent a cost of doing business.

    But when "it" hits the fan, if the CVA desk has done its job, then they can literally save the bank, and that's potentially a huge source of reward.

    Don't they deal with external clients (rather, counterparties) when they hedge the net exposure in the market?

    yes indeed, they are fully active in the external market, but then they're market takers, not makers. In other words, they're the client. Perhaps my characterization of "middle office" is misleading, now that I think of it. Rather, they're part of the risk control function, which some banks breakout separately into counterparty risk.

    Put it this way. The term "front office" of a bank inherently involves selling. Traders, Researchers, and Salespeople are engaged with providing services to their clients, in various ways. That is not the case for CVA - they are there to help create the conditions for those services to be offered by the front office, by optimizing one aspect of risk. Indeed, it is important that CVA does NOT report to front office, as this would be a conflict of interest. Keep this in mind though: CVA people have all the skills and training to become excellent prop traders or portfolio managers.

    I'll add one final point, and that's about culture. The "culture" of the front office is *taking* risk, wherease the culture of the CVA desk is inherently to reduce risk. If you're asking this question in relation to career choice, you need to keep this in mind, as the training you will receive and the instincts you may develop on markets, will obviously be affected.

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Content dated before 7/24/2021 11:53 AM

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