Counterparty Risk
Ameya Abhyankar
Founder, FinQuest Institute
Learning Outcomes
• Introduction
• Lending Risk Vs Counterparty Risk
• Settlement Risk Vs Pre-settlement Risk
• Methods to mitigate counterparty risk
• Components of counterparty risk/exposure
• Limits Monitoring framework
Introduction – Counterparty Risk
Counterparty Risk also called as Counterparty Credit Risk explains the risk that the counterparty may
not meet their side of the obligations
This is a kind of risk that is studied at the intersection of credit risk and market risk. As we will discuss in
the subsequent slides, there is a central role that is borne by MTM valuations, exposure limits to
counterparties etc.
Counterparty Risk is many a times confused as Lending Risk. There may be certain similarities but there is
a subtle difference between the two. Understanding this is crucial for getting a good hold on counterparty
risk.
Lending Risk Vs Counterparty Risk
Comparing Counterparty Risk with Lending Risk
Although related, there are subtle differences between these two types of risk
a. Lending Risk:
o There is a fair amount of certainty as to the notional amount that may be at risk at any point in
time
o Market parameters like interest rates etc. do not have a very significant impact on this
o For instance, consider a home mortgage on the books of the bank. The bank know the amount
at risk. Similarly for credit cards, there is a maximum usage facility prescribed
o Only one party takes on credit risk i.e., say bondholder takes on credit risk, but not the bond
issuer
Lending Risk Vs Counterparty Risk
b. Counterparty Risk
o The value of the contract in the future (i.e. MTM) is uncertain. It may swing from positive to negative
based on market fluctuations
o Counterparty risk is typically bilateral in nature
Settlement Vs Pre-settlement risk
There are two types of risk that banks face in a derivatives transaction:
a. Pre-Settlement Risk: This is the risk that the counterparty may default prior to the settlement date of
the contract
b. Settlement Risk: This risk arises at maturity date of the contract. Many a times due to the timing
differences between each party performing its obligation
Popular example of settlement risk is Bankhaus
Herstatt that happened in 1974
Settlement Risk
Pre-settlement risk will keep moving based on the daily MTM of trades done by the counterparties
Settlement risk can be of main concern especially when dealing with FX and FX linked derivatives
Settlement risk may run from a few hours generally, however, it can be a cause of concern for banks
Systems like Continuous Linked Settlement (CLS) is a popular way to mitigate settlement risk
Delivery versus Payment (DvP) principal
Most banks monitor pre-settlement exposure, settlement exposure and total exposure for individual
trading counterparties which allows them limits monitoring
Methods for mitigating counterparty risk
Below are popular types of mitigants for managing counterparty credit risk:
o Netting
Difference between gross payments and net payments
Netting agreements allow cashflows appearing on the same day to be netted with each other
In case of default, the MTM values can also be combined into a single net amount
Parties need to be careful to ensure legal enforceability of netting in certain jurisdictions
o Collateral
Cash or cash-like collateral may be posted against MTM losses
Daily collateral exchange via Credit Support Annex (CSA) agreements has become like an industry standard. However,
following are the factors to be considered.
a. Liquidity Risk: Collateral payment will need to be funded by counterparties and the collateral itself can carry risk of FX
volatility and price risk
b. Market Risk: exposure exists in the time taken for receipt of relevant collateral amount
c. Operationally intensive: This can be a operationally intensive exercise especially daily CSA exchange
Methods for mitigating counterparty risk
o Hedging instruments
Credit Default Swaps (CDS) can be a way to mitigate credit risk
Hedging does create some market risk (due to MTM volatility of the hedging instruments)
o Central Counterparties (CCPs)
CCPs play an important role in guaranteeing clearing & settlement of transactions
CCPs operate on the idea of centeralization of counterparty risk; considerable amount of collateralization and
loss mutualisation in case of default
While CCPs offer benefit of relieving counterparties from the burden of counterparty credit risk management,
they expose them to liquidity risk, operational risk
CCPs are systemically important financial institutions, and a default by a CCP is a catastrophic event for the
market
o Other mitigants
Feature for early termination of contracts
Components of Counterparty Credit Risk
Below are the two main components of counterparty risk namely:
o Replacement Cost
o Future Exposure
Replacement Cost
o MTM of the contract will keep on fluctuating based on the changes in market risk factors
o MTM with respect to a counterparty defines the net value of all positions and is therefore directly related to what
could potentially be lost today in the event of a default
o Replacement cost attempts to approximate the cost for entering into a similar contract with another counterparty (in
the event of the original part defaulting)
o This is only an approximation, because the actual cost of entering into a new trade will be clear only at the point of
time when original party defaults and the existing market conditions at that point in time
o Mark to Market (MTM) is considered as a good proxy for replacement cost
Usage of replacement cost idea in Exposure reporting (eg: RCA3 filings)
Components of Counterparty Credit Risk
Future Exposure
o This factor takes into consideration the fact that the derivative trade has a long time to maturity
o We need some way to quantify the risk of counterparty default
o Generally the methodology for calculating this component is defined for each product type and across different
time buckets
Total Credit Exposure for a counterparty = max(Replacement Cost,0) + Future Exposure – Collateral received
Replacement cost may be positive or negative. From the exposure point of view we worry only about the positive
value.
Idea of Limits Monitoring framework
Limits Monitoring
Limits framework plays a key role in monitoring the exposures to individual counterparties
Policy framework linkage with Limits settings
Role of the Risk Committee
Ownership of the Limits framework (FIG)
Administering and monitoring of risk limits (Risk)
Temporary revision of risk limits (trade v treasury)
Handling of breaches in counterparty risk limits
Annual review of limits framework
Trading with counterparties based in countries that are considered politically sensitive
Thank You
ameya@[Link]
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