Counterparty Risk Management and OTC Derivatives

Counterparty risk is the risk of a counterparty in a transaction defaulting before the expiry of the contract and accordingly being unable to make agreed contractual payments. In such an event, the risk can be seen as the equivalent of the replacement cost, which would be the cost of replacing the existing and defaulted transaction at current market rates to meet the contractual obligations. At times it is possible that the counterparty defaults on the day of expiry of the contract, after the other party has met the obligation under the transaction. In this scenario, the loss would be the entire value of the transaction.

At a fundamental level, counterparty risk can be addressed by prescribing limits for currencies, jurisdiction, maturities and products per counterparty. This requires a detailed financial analysis and performance of the counterparty and the associated country risk factors. When a counterparty is new or when such limits are fully utilised and there is a need to take additional exposures with the counterparty, a firm can address such risk by posting securities as collateral.

This article mainly looks at counterparty risk in the context of over-the-counter (OTC) derivatives, as this is an area that not only involves high levels of risk for the market participants, but also has been under the regulatory purview of leading regulators globally, as they endeavour to create an infrastructure that would reduce the levels of counterparty risk and help them better manage the rising levels of systemic risk in their respective economies.

The Lehman debacle and the global financial crisis have made clear the importance of counterparty risk management in today’s financial world. Participants in the OTC derivatives market require the creditworthiness, liquidity and operational robustness of their counterparties on a continued basis. In a bilateral market, this is particularly true for dealers, which act as market-makers by accepting clients’ trades and then entering into matching contracts with other participants. The existence of counterparty risk, which involves the risk embodied in the positions that would have to be replaced if the counterparty were to default, makes it more difficult to manage financial risks arising from derivatives. This means that the designing of hedging strategies also becomes more complicated. These more complex techniques complement the basic counterparty risk management processes, such as diversification and ongoing due diligence, that continue as a central element of risk mitigation.

Counterparty Risk Management for OTC Derivatives

As would be expected after the severity of the financial crisis, there has been a sea-change in the past couple of years in the way counterparty risk is being managed for OTC derivatives. The market participants are much more aware of the methods they need to use to account for counterparty risk. On their part, the vendors have also started producing solutions that calculate counterparty risk very differently from the way it was done earlier. At the time of the Lehman crisis, firms were struggling to find out their exposure in the market.

Today, the leading solutions look at counterparty risk in realtime. Various calculations are available to study the risk for a particular trader, division, firm or overall group. This is a stark contrast from the static approach employed earlier by the market participants, which involved taking snapshots of the risk levels at certain points in time. More often than not, these calculations were redundant by the time they were undertaken as the risk levels had changed greatly in the meantime.

The Impact of Regulation

Besides an improvement in the way risk is being measured by market players, tighter regulation also is going to play an important part in the coming years. The move towards central counterparty clearing (CCP) under the Dodd-Frank Act (DFA) in the US and the European Market Infrastructure Regulation (EMIR), along with the earlier commitments made by the G-14 banks in September 2009 to use CCP mean that CCPs such as Intercontinental Exchange (ICE) and LCH.Clearnet are going to become even more important in the OTC derivatives market than they are already.

In the Asian context, while we are not likely to see a change in terms of execution, leading exchanges such as TSE in Japan, SGX in Singapore and HKEx in Hong Kong have started creating the central clearing infrastructure for OTC derivatives. The regulators in the leading markets in Asia all agree on the need for clearing for OTC derivatives and hence we should expect it to become a reality in the near future.

In the US, execution is going to move towards Swap Execution Facilities (SEFs), with most of the standardised OTC derivatives being cleared at the CCPs. It is expected that over 70% of the US OTC derivatives market is going to be centrally cleared in the coming years. This would require a great deal of standardisation in the designing of the derivatives and also need a large market infrastructure to be put in place that can cope with such volumes. Naturally, as the nature of the counter parties changes, the way counterparty risk would be assessed and managed would also change. While they will still have a part to play in the market, the role of prime brokers and market makers is going to diminish in the next few years.

What these changes would do is hopefully to reduce counterparty risk through the CCP model, but also lead to a situation in which the risk is much more concentrated in the CCPs and the leading investment banks which would be main clearing brokers. It is expected that the cost of margining might make it prohibitive for most of the buy-side and small regional banks to become clearing members themselves and hence they would have to use clearing brokers. This is expected to create a two-tier market, with the leading broker-dealers at the first level and the smaller banks and buy-side at the second.

Furthermore, the most likely scenario is one in which a CCP dominates the clearing for an OTC derivatives product. Hence, interest rate swaps (IRS) clearing is likely to be dominated by the European clearing-house LCH.Clearnet which clears about half of the global IRS volumes at present. Similarly, credit default swaps (CDS) are likely to be cleared mainly by Intercontinental Exchange (ICE) in the US and Europe, and to a smaller extent, Chicago Merchantile Exchange (CME) in the US. ICE has already been clearing large volumes of credit derivatives in the course of 2010 and 2011, and is expected to continue its early domination. In Asia, leading markets such as Japan, Singapore, Hong Kong, China and India will all have their own CCPs by 2011-12. In Singapore and India, for example, these are already operational. In Australia, the regulator has invited existing CCPs, such as those in US or Europe, to provide coverage of the Australian market, probably to allow the benefits of economies of scale.

Clearing Connectivity

On the clearing connectivity side, 10-15 leading brokers are likely to be the main clearing members at each of these CCPs. As a result, from a diverse bilateral market, the global OTC derivatives market is going to move towards a more centralised concentrated model for clearing. This has ensuing implications for risk as well, as the CCPs become ‘too big to fail’ institutions and their financial health becomes a constant source of worry for the regulators and market participants alike. Therefore, while at a firm or micro level the use of a CCP is expected to reduce counterparty risk, fundamental concerns would still remain at the macroeconomic level for the regulators. On a positive note, the use of data repositories is going to increase transparency for market players and they would find it easier to assess the overall risk levels in the market. These repositories would also allow the various leading regulators to monitor the risk in the OTC derivatives market.

The greater cooperation between regulators and awareness of the issues needed to be kept to manage counterparty risk, along with improved risk management systems that allow participants to assess their counterparty risk levels in real time means that we are in a better position than we were immediately after the Lehman crisis. However, as discussed, a lot more needs to be done to ensure that there is no false sense of complacency simply due to the higher volumes being cleared through the CCP model. In a way, we are transferring risk from one type of model to another, not getting rid of it altogether. So, continued diligence on part of the OTC derivatives’ market participants and the regulators is warranted.

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