13.The calculation allows banks to recognize the risk mitigating benefits of certain eligible CVA hedges. The Standards allows only certain types of instruments to serve as eligible hedges for CVA, specifically an index credit default swap (CDS), or a single-name CDS, single-name contingent CDS, or equivalent hedging instrument that directly references the counterparty being hedged. An option on an eligible CDS (that is, a swaption on such a CDS) can be eligible, provided the swaption does not contain a “knock out” clause that terminates the swaption in the case of a credit event. Eligible hedges that are included in the CVA capital charge are removed from the bank’s market risk capital calculation.

14.Other types of instruments must not be reflected as hedges within the calculation of the CVA capital charge, even if the bank views them as mitigating counterparty credit risk. For example, tranched or nth-to-default CDS instruments are not eligible CVA hedges. These instead must be treated as any other similar instrument in the bank’s portfolio for regulatory capital purposes.

15.In addition to the restrictions regarding the types of instruments that a bank may recognize as CVA hedges, only transactions entered into explicitly for the purpose of hedging the counterparty credit spread component of CVA risk can be eligible hedges. This means, for example, that a bank might have a single-name CDS referencing an OTC counterparty in its portfolio, and yet that CDS would not be eligible to offset the single-name CVA exposure within the CVA calculation if that CDS was not originated or acquired as part of the bank’s process to manage CVA risk for that particular counterparty.

16.To clearly demonstrate intent to manage CVA risk, the bank should have a documented CVA risk management process or program, so that any CVA hedging transaction is demonstrably consistent with the design and operation of that program, was entered into with the intent to mitigate the counterparty credit spread component of CVA risk, and continues to be managed by the bank in a manner consistent with that intent. The Central Bank expects that any bank wishing to recognize the benefits of hedges in CVA capital calculations will maintain policies and procedures to govern this process. If the Central Bank concludes that a bank’s CVA hedging policies and procedures are inadequate, the Central Bank may limit the bank’s ability to recognize hedges in CVA capital calculations.

17.Another key principle for CVA hedging is that risk mitigation should transfer risk to third parties external to the bank. Some banks use internal transactions to transfer risk between different desks or business units within the bank as part of a broader risk management program, with these transactions typically subject to some type of internal transfer pricing mechanism. Such transactions are permissible and can be a valid component of the management of CVA risk within a bank, but the risk ultimately should be transferred out of the bank, which generally requires a corresponding external transaction to reduce CVA risk.