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Mark Petit and Jeroen van der Hoek of Cardano explain the nature of counterparty risk in some of the most common over the counter (OTC) transactions and discuss how investors in OTC markets have fared in these testing times

The recent market turmoil has reinforced the importance of adequate risk management, including dealing with exposure to counterparties. The most important lesson from the crisis is that most investors in these markets experienced remarkably little downside, provided they had proper counterparty risk management practices in place.

What is counterparty risk?

Counterparty risk (also referred to as credit risk or default risk) is the risk that your counterparty in a transaction cannot honour its obligation to you. For example, you have bought a corporate bond from company XYZ, expecting to receive coupon payments and the nominal value of the bond at maturity. Under this transaction, you are exposed to the risk that XYZ can’t pay you the coupons and principal at the agreed point in time.

Another example is an equity put option bought on the OTC market. If markets plunge, as they have done in recent times, the mark to market value of the put option increases sharply, introducing significant counterparty risk to the buyer of the put option. Similar risk exists in swaps, swaptions, and inflation linked swaps.

Why is counterparty risk important to me?

Counterparty risk is widely present in financial markets, and is a risk experienced by all sorts of investors, both large and small. For example, all investors in bonds (or any other type of loan) take on a certain amount of counterparty risk, especially when investing in corporate bonds. Most fixed income investors are aware of this and are actually making an informed decision to take on this extra credit risk in return for higher yields.

Large institutional investors are no strangers to counterparty risk, either. This particular group of investors widely uses equity put options, swaps, swaptions and inflation linked swaps to hedge their market risk. Almost all these transactions are executed in the OTC market, simply because the listed market does not offer the right type of hedging instruments for them. In the OTC market, (investment) banks are taking on the other side of the transaction.

Hence, by nature, most large institutional investors have to cope with a great deal of counterparty risk. As the fall of Lehman Brothers has illustrated, perceived protection in reality will be worthless in case of a default of the hedge provider — unless you are prepared and know how to deal with counterparty risk.

Has counterparty risk increased due to current market conditions?

Certainly the awareness of counterparty risk and risk in general has increased dramatically in recent months. Counterparty risk has always been present, but it simply did not emerge on the radar of the general public until now.

The current ubiquitous awareness of counterparty risk is illustrated by dramatically increased credit spreads, downward adjustments of credit ratings, and the increased number of bankruptcies and takeovers in the financial industry. To illustrate this point, average credit spreads for banks (A- to AA+ rated) have increased from around 15bp (January 2007) to 200-500bp (October 2008). This has led to a decrease in the number of counterparties that are able and willing to take on risk of institutional investors, and an increase in the probability that these parties will eventually default on their obligations.

How can I mitigate my counterparty risk?

To answer this question, it is worthwhile to see how large institutional investors and banks cope with counterparty risk. As already mentioned, they are active players in the OTC market and counterparty risk is an everyday fact of life for them. As we will see, hedging counterparty risk is in fact quite easy to achieve, and OTC market participants have been very successful at it.

What has proven to work best is a structured approach’ towards counterparty risk, and it involves three steps — counterparty selection, documentation and collateral management.

Step one involves the initial selection of counterparties. An in-depth assessment of possible counterparties based on a number of criteria, such as credit rating, credit spread, and experience in trading a particular instrument (in other words, a sizeable and active trading book) is usually required. In addition, the willingness to accept counterparty risk mitigating actions, laid down in legal documentation, can be decisive in selecting your counterparty.

After a shortlist of credible potential counterparties has been made, International Swaps and Derivatives Association (ISDA) documentation has to be drafted. This is step two in the process. Having the right documentation in place is crucial for success.

The ISDA documentation consists of three parts — the master, the schedule and the credit support annexe (CSA). Each plays its own part in the entire process, but it is the CSA that deserves the most attention in the context of counterparty risk. The CSA specifies the rules of collateral management, which is really the Holy Grail to managing counterparty risk. In the CSA, parties can agree at what levels of exposure collateral needs to be posted (for example, threshold amount and minimum transfer amount), which instruments to use as collateral, what the frequency of posting collateral is going to be, and so on.

In addition, parties can decide whether or not collateral has to be physically transferred to an external investor’s account, which is fairly standard in European derivatives markets, or that collateral remains with the counterparty under a pledge agreement.

After documentation has been drafted and the transactions have been executed, the final step is performance of collateral management itself. Drafting a CSA is one thing, but acting on it and managing your collateral in an appropriate way is another. Current market turmoil has proven that continuously monitoring of and timely reporting on counterparty risk is extremely valuable.

Both banks and large institutional investors are experienced in dealing with documentation and collateral management. In practice, large losses due to counterparty risk are almost exclusively due to inadequate documentation and/or lax performance of operational collateral management.

Can you provide an example of the potential monetary consequences of the presented structured approach, in particular the CSA?

In the CSA, parties can address and minimise counterparty risk by negotiating a number of parameters. We will give a brief description of the most common ones:

A threshold amount has to be set for both parties. This amount is a reference value of the mark to market of the outstanding transaction above which collateral has to be posted. For example, if the threshold amount is 5,000,000 for a party, this party is required to post collateral only when the mark to market level of the transaction reaches above 5,000,000; Parties need to agree on the frequency of collateral posting. Often, applied frequencies are daily, weekly, and bi-weekly, meaning collateral calls can only be placed every day, weekly, or bi-weekly respectively; The assets that classify as eligible collateral need to be negotiated. If securities are to be used, it is necessary to define a set of eligible instruments along with the associated haircuts. Cash and government bonds are generally the most common eligible instruments; A minimum transfer amount (MTA) needs to be determined. If the difference between the mark to market and the value of the present collateral position is in excess of the MTA, extra collateral needs to be posted.

To illustrate the potential working of a CSA in practice, let us consider two parties with the same trade — a long position in an option. We also assume both parties have executed the trade with the same counterparty. However, both parties have drafted different CSAs.

Table 1 shows the details of both CSAs. We assume a threshold amount of zero for both parties and for simplicity we will ignore any other potential clauses of CSA’s.

Table 2 shows the hypothetical periodic development of the mark to market of the outstanding trades, and the amount of collateral both parties will receive from their counterparty. Positive mark to market means the trade is in-the-money from the client’s perspective, and the counterparty is required to post collateral.

From Table 2, we can observe:

Party two is exposed to significantly more counterparty risk, compared with party one; If the counterparty defaults after four periods, party one has collateral equal to the mark to market and should incur no loss. Party two incurs a loss of 550,000, because the MTA of party two has not been hit; If the counterparty defaults after six periods, party one incurs a loss of 350,000, because the difference between t he mark to market and the value of present collateral is less than the MTA. Party two incurs a loss of 900,000; If the counterparty defaults after eight periods, party one incurs a loss of 450,000 and party two incurs a loss of 1,750,000.

As our example shows, different parameter settings can have significantly different outcomes in case of a default. Of course, each party has to strike a fine balance between reducing risk on the one hand and increasing operational and implementation risk on the other hand. Investors can, for example, link parameter settings to the credit rat ing of the counterparty, demanding more stringent clauses when dealing with counterparties with lower credit ratings.

Though hypothetical and stylised, the example paints a clear picture: A CSA and sound collateral management significantly reduce counterparty risk in extreme market conditions.

What are the costs of reducing counterparty risk?

There are no direct monetary costs involved, other than time spent on drafting documentation and potential external legal advice. However, drafting a CSA really is a negotiation between two parties. Not anything goes and every clause has its particular value to each party involved, and hence a price. For most investors, seeking external legal support when drafting documentation seems therefore sensible. Also, advice is often sought with respect to the real economic and monetary consequences of what is drafted in documentation. In addition, having an experienced and sound collateral management operation in place is a necessity.

Given the potential disastrous consequences of not addressing counterparty risk in a proper manner, the costs of drafting documentation and subsequent collateral management are negligible.

What lessons for the future should we learn from the current crisis?

A few years ago, many institutional investors were happy to trade in the OTC market without a CSA, or on terms dictated by (and hence in favour of) the counterparties. The current crisis has put risk, and especially counterparty risk, back in the spotlight and has illustrated the importance of managing counterparty risk.

As painful as it may be, the current crisis has also proven to be the best stress test imaginable for investors in the OTC derivatives market. Since inception of the OTC derivatives market in the 1980s, people have wondered how effective managing counterparty risk would be in distressed markets, with high levels of market risk as well as actual bank failures. The current financial crisis includes all these ingredients. Having appropriate documentation in place combined with an experienced and sound collateral management operation has most certainly proven its value.

In conclusion, if properly addressed and with adequate processes in place, counterparty risk can easily be reduced to a low level — even in extreme market circumstances, when the market risk reduction provided by these instruments has proven very effective to many pension funds.