Until the collapse of Lehman Brothers in September 2008, counterparty risk was not seen as a priority for corporate treasurers. Now, being able to identify your overall exposure – in a timely manner – to a particular entity is crucial. Unfortunately, this is not straightforward in a world of global transactions where, although the initial counterparty might be easily identifiable and financially sound, their counterparties might not be. But are treasurers yet managing counterparty risk adequately? For example, where does it fit in with the other risk categories? Although banks are addressing this, corporates are still lagging behind, despite a growing awareness of its importance. This is largely because this level of detail is hard both to come by and to consolidate.
There is a strong reputational element to counterparty risk, and the ‘ripple’ effect, with the potential for client loss, can be far-reaching. Christopher Finger, head of research and communications at risk consultancy MSCI explains that their research of non-bank entities had shown that a key way of measuring this was becoming a counterparty to a financial institution in distress. “When a financial institution is in distress and the Wall Street Journal [shows] who’s got really large exposures to them, we don’t ever want to be on that list,” he says.
“The counterparty story is about being able to quickly identify what an overall exposure is to a particular new entity,” Finger says. “The real challenge is that the entity to whom you’re going to be exposed is global and you are global. That includes the swaps your Japanese subsidiary is doing with your bank’s Asian business, just like it includes the currency forwards you’re doing with them in London. Without aggregating that globally, you’re not really dealing with the problem, ” he says.
Determining exposure can be problematic partly because it is, by definition, most likely to be present in a global context. Counterparty risk arises in many cases due to hedging programmes, which are only relevant where there are significant exposures globally, rather than regionally or at business unit level to the things that you might want to hedge with a financial contract. “It’s only if you’re doing things globally, where you’re considering your dollar/euro exposure offset across all my different business units etc, that you’re likely to be examining my overall exposure to Citigroup or Deutsche Bank, for example,” Finger adds.
Manmohan Singh, global head of product leadership, at software provider Information Mosaic, points out that transacting globally could also have country risk associated, such as the recent, well-documented market failures in Greece and Iceland, and dealing with multiple counterparties means the associated risks are also multiplied. “Which currency are you risking in?” he asks? “Are you carrying US dollars, which just lost their footing, or transacting with a country where the ratings have plummeted?”
It seems, therefore, that, aside from the early adopters with a global treasury function, corporate treasurers as a group have not yet started to get to grips with counterparty risk. This is partly because of the change in dynamic between banks and corporates. Because previously it was only banks that were exposed to counterparty risk, rather than their clients, their awareness of the issues is much more developed. Other financial institutions, such as asset management firms, asset owners and hedge funds, have also now started carefully to consider this issue. However, some argue that the same cannot be said for corporate treasurers.
“We haven’t seen the urgency in corporate treasuries that we have in financial institutions. There’s been a sea change in the broader set of financial services firms outside banking, but I would not characterise it as a groundswell on the corporate side,” Finger notes. One reason for the lack of counterparty strategy risk development among corporate treasurers as a group is, of course, the cost of implementation, particularly since business risks might be seen as higher or more urgent. Finger says there is “still some convincing to be done” as business risks in many cases still have the most attention and the nature of those risks changes over time. “I think in many cases the risks of financial counterparties is not at the top of the list,” he adds.
Actually identifying the level of risk is another matter. Unlike for other types of risk, data is not readily available, unlike with internal data, and an authoritative external source for this doesn’t exist. Gert Raeves, vice president, partnerships and marketing of data management provider GoldenSource, comments: “Our experience is that customers tend to still very much build their own databases rather than sourcing that data from a financial data provider.” This means that obtaining basic counterparty’s information such as legal entities and tax identity. However, to accurately gauge counterparty risk exposure, knowing the single legal entity/corporate entity exposure is not enough. The treasurer also needs to track exposure to subsidiaries and joint ventures as well as sub-entities or single corporate entity. Each of those corporates and subsidiaries and joint ventures will have, in many cases, their own instrument issuance activities where they’re putting out equity fixing, current papers, convertible tests, warrants and other various derivative instruments, across the corporate hierarchy chain.
This hierarchy information is harder to source than legal entity data. Raeves explains that even for the basic acquisition of data, and using vendor sources, a lot of the enrichment – the desk analysis of a hierarchy of counterparty data – is required, using in-house analysts – and this is only the beginning of the process. “Let’s assume that you’ve done all the hard work, acquired all of the core counterparty data to identify the legal entity tax domicile residency,” Raeves says. “You have also been able, by hard graft and clever purchasing, to build the hierarchy data that goes with that. You then still need to map that and link that to the data of the instruments being issued, traded, valued and guaranteed by those counterparties. So linking the actual finance data with that whole hierarchy chain, that’s where it gets really hairy for people in order to build a better picture of counterparty risk and risk exposure.” Some vendors offer services that link financial instrument/product data with counterparty hierarchy data.
Raeves has seen a change in treasury focus in this area, seeing a greater demand for integration. “Our bread and butter business, three or four years ago, would have been the more standalone counterparty data and onboarding solutions as well as the financial instrument security master data repositories,” he says, noting that it is the links between those two that have come more to the forefront, both in relation to counterparty risk exposure but also at the level of issuer relationships.
In line with the move towards a greater level of operational integration, treasurers are also starting to extract counterparty risk data from the database in order to share it with other business applications and functions. This is achieved by placing it in a counterparty risk, collateral management and margining, foreign exchange (FX) and overlay programme.
Many organisations still lack awareness of the limitations of their IT infrastructure as it relates to counterparty risk. Manmohan Singh says that the lack of a real-time picture of counterparty risk is impeding companies. “The big institutions, even today, have a backdated view. They don’t have a real time access to their counterparty risk information, even though the technology for this is taking shape and should be a great boon to treasurers.” However, he adds, treasurers were starting to invest in post-trade risk analysis. “People seem to be setting their caution aside and gradually moving into automation in this area and focusing on achieving real-time view.”
A Move to MMFs?
The fall in the number of eligible counterparties has seen some corporate treasurers take a step away from bank deposits in favour of money market funds (MMFs). Corporates are diversifying as they seek to place their cash with low-risk instruments and vehicles as their investment policies become more stringent and their banks’ ratings have fallen. Justin Meadows, chief executive of electronic trading platform MyTreasury, explains: “One of our users told us in the last month that they used to have 100 eligible counterparties they could deal with but are now down to 19. So they’re having to look at alternatives all the time,” he says. With their AAA-rating, their credit is deemed sound, and the fact that it’s not single counterparty risk means the investment has no impact on a company’s relationship banks and the holdings it has with those. Meadows says this represents a change of policy for some companies since the collapse of Lehman. “We’ve been opening new accounts for existing clients – quite a few have not used funds before or they’d come out of them after Lehman and hadn’t gone back in,” he says. “A number of those have now come back, reactivated the discussions and negotiations, and are going into funds,” he adds. Regionally, this is particularly true of the Benelux countries and Germany.
The fact that many banks, which companies nevertheless enjoy a good relationship with, no longer meet their criteria is a thorny one touched on in a recent Association for Financial Professionals (AFP) Annual Conference debate on the subject. Panellist Ramon Uribarri, certified treasury professional (CTP), global treasury analyst at International Paper Company described the process as “like turning a supertanker”. “You have to look at your long-term strategy with a certain bank if it is suddenly not meeting your requirements,” he added.
Although not yet a fully developed process for many, counterparty risk management for corporates has started to become much more meaningful. Companies are taking steps to reduce their exposure in a concrete way and consider where data gaps exist rather than merely following a ‘box-ticking’ process as in the years before the crisis. Deeper analysis is starting to take place – and where information is not yet available, this awareness is spurring firms to look more deeply into the way it is gathered and shared. As GoldenSource’s Raeves puts it: “We see that in order to reassure vendors, regulators and customers, our customers are starting to get right down into the detail of how they manage the underlying data sets.”
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