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If a bank owns an unmargined OTC derivative contract with mark to market valuation of \$X, is it required to borrow \$X from money markets in order to post that asset's value to its balance sheet? If so, what is the reasoning behind this requirement (rather than simply including the derivative's mark to market value on its balance sheet without needing to borrow that amount)?

I have read internal resources that imply this, but have not been able to find anything publicly available that confirms and explains this.

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    $\begingroup$ According to this comprehensive summary no such borrowing is required. Can you give a bit more background why you think this might be implied? $\endgroup$
    – Kurt G.
    Aug 28, 2021 at 7:26
  • $\begingroup$ Hi @KurtG. - I work at an investment bank, and have seen multiple internal documents stating this. However those documents do not explain why! $\endgroup$
    – Trent Gm
    Aug 31, 2021 at 0:46

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Ok so let’s say we have an asset on the balance sheet which is the market value of an unmargined derivative. A common procedure by banks is to assume this is financed by unsecured borrowing. Why ? I suppose there are two cases (a) the derivative has been hedged with a margined contract going in the opposite direction. In this case the margined contract is a liability, for which the bank has to raise cash. Thus, we have a requirement for unsecured borrowing. Or, (b) (less likely) the contract was unhedged, so it represents a pure gain . In this case, the balance sheet reflects this gain by an increase of retained earnings within shareholder equity. However one assumes that the bank will maintain its desired capital structure at a certain ratio , so in the end the bank will repurchase some equity and instead take out unsecured borrowing , as before.

So yes, gains on unmargined derivatives are generally financed by unsecured borrowing and are internally costed as such.

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  • $\begingroup$ I've read explanation (a) before, and it doesn't make sense to me. Why would the decision to hedge a trade affect it's valuation. Also worth noting that the funds put into margin would usually earn interest. Further worth noting that it's common for banks to leave part of their position unhedged. (b) is a more self consistent explanation, but not sure how true that assumption is... $\endgroup$
    – Trent Gm
    Aug 31, 2021 at 12:43
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From a pure accounting perspective under IFRS 9, there is no requirement like this for putting it on the balance sheet.

Every derivative, regardless of margined or unmargined, gets posted to the balancesheet to its Fair Value. For uncollateralised derivatives, this means $FV = MtM("riskless") - XVA$, while for collateralised derivatives, it is best practice to neglect $XVA$.

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  • $\begingroup$ Looking at pwc.com.au/pdf/xva-explained.pdf as a primer to XVA, the pdf writes "Captures the funding cost of uncollateralised derivatives above the ‘risk free rate’.", implying some sort of funding cost for uncollateralised derivatives. Further down the pdf writes "Similarly, a funding cost arises for the bank when a derivative has a positive market value. The purchase of an ‘in the money’ or asset position derivative requires the bank to pay cash.", which is clearly true to me, but what funding is there for a derivative that becomes in the money. $\endgroup$
    – Trent Gm
    Aug 31, 2021 at 12:50
  • $\begingroup$ You are pointing on a conflict between accounting and trading. As dm63 pointed out, derivative desks are charged the bank's average funding costs. Therefore, they have to make a FVA to uncollateralised derivatives. If they don't do this, there will be a loss on trades that are collateralised. But under IFRS 13, the FV is the exit price of a derivative, hence funding costs of the bank should be irrelevant, since the market price matters. However, in practise, FVA gets incorporated in the FV. Have a look at Hull, White (2013): "Valuing Derivatives: Funding Value Adjustments and Fair Value" $\endgroup$
    – simzoor
    Aug 31, 2021 at 16:06
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    $\begingroup$ In your example, if there is no hedging with a collateralised trade, afaik there are no funding costs. $\endgroup$
    – simzoor
    Aug 31, 2021 at 16:30

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