How does CVA differ between bilateral and centrally cleared derivatives, and why do regulators treat them differently for capital purposes?

Credit Valuation Adjustment (CVA) represents the expected loss due to counterparty default on derivative exposures. The treatment differs dramatically between bilateral and cleared trades because of the structural protections CCPs provide.\n\nBilateral CVA:\n\nFor bilateral (non-cleared) derivatives, CVA is calculated as:\n\nCVA = -LGD x integral from 0 to T of EE(t) x dPD(t)\n\nApproximated discretely:\nCVA = Sum over t of: LGD x EE(t) x [PD(t) - PD(t-1)]\n\nwhere EE(t) is the discounted expected exposure at time t and PD(t) is the cumulative default probability.\n\nWhy Cleared Trades Have Minimal CVA:\n\n| Protection Layer | Bilateral | Cleared |\n|---|---|---|\n| Variation margin | CSA-dependent, possible thresholds | Daily, no threshold |\n| Initial margin | SIMM or negotiated | CCP-mandated, stress-calibrated |\n| Default fund | None | Mutualized loss absorption |\n| Assessment powers | None | CCP can call additional funds |\n| Close-out period | 10-20 days | 5 days (standardized) |\n| Loss allocation | Bilateral exposure | Default waterfall |\n\nThe CCP default waterfall ensures that a clearing member's default losses are absorbed by:\n1. Defaulter's initial margin\n2. Defaulter's default fund contribution\n3. CCP's own capital (skin-in-the-game)\n4. Non-defaulting members' default fund contributions\n5. CCP assessment powers\n\nWorked Example:\nAshford Capital has a 5-year interest rate swap with two counterparties:\n\nBilateral with Greystone Bank (BBB-rated, no margin):\n- Expected exposure profile peak: $8.2 million at year 3\n- 5-year CDS spread: 185 bps\n- LGD: 60%\n- CVA charge: approximately $482,000\n\nSame swap cleared at LCH:\n- Exposure after IM: near zero (IM covers 99.7% of 5-day moves)\n- CCP default probability: treated as negligible\n- CVA charge: approximately $0 (2% risk weight on trade exposure for capital)\n\nRegulatory Capital Treatment:\n\nBasel III applies a 2% risk weight to CCP trade exposures versus full counterparty risk weights (20-150%) for bilateral trades. Default fund contributions to qualified CCPs carry a specific capital charge calculated from the CCP's hypothetical capital requirement (K_CCP).\n\nBilateral CVA Capital Charge (BA-CVA):\n\nThe Basel CVA capital framework now includes both spread risk (changes in counterparty credit quality) and exposure risk (changes in the derivative's market value). This can add 30-50% to bilateral derivative capital costs versus the pre-CVA framework.\n\nStrategic Implications:\n- Banks actively migrate bilateral portfolios to clearing to reduce CVA capital\n- Remaining bilateral trades face higher pricing to cover CVA costs\n- CVA hedging desks use CDS and contingent CDS to manage bilateral CVA volatility\n\nExplore CVA modeling in our FRM Part II course.