This post discusses counterparty risk and counterparty risk management.

WHAT IS COUNTERPARTY RISK?

Counterpart risk is the potential loss arising from the failure of a party to a derivative contract (e.g., a forward contract or swap) to fulfil its obligations towards the other party. Counterparty risk is the probability that the other party in an investment, credit, or trading transaction may not fulfil its part of the deal and may default on the contractual obligations. What happens when a financial counterparty defaults on contractual duties, i.e., it stops paying out what it turned out to be owing to the other counterparty? 

In derivatives contracts, parties agree to exchange cash flows based on the price of an underlying asset. A corn farmer wishing to lock in the price he receives for his crop, for example, may sell a futures contract that will pay him more as the cost of his corn falls, locking in his financial outcome. In a derivative securities exchange, a clearinghouse acts as an intermediary, serving as the counterparty to each transaction side and ensuring performance if one party fails to perform on its contractual obligations. This arrangement allows investors to trade with confidence.

Furthermore, the counterparty risk arises in an option contract when the option writer refrains from buying or selling the underlying security defined in the contract. An intermediary (literally a clearinghouse) between the two counterparties can eliminate or reduce this risk. As with futures contracts, it guarantees the parties’ performance in each transaction. For example, you have bought a corporate bond from ABC, expecting to receive coupon payments and the bond’s nominal value at maturity. Under this transaction, you are exposed to the risk that ABC cannot pay you the coupons and principal at the agreed point in time.

TYPES OF TRANSACTIONS INVOLVING COUNTERPARTY RISK

Here are some of the everyday transactions that may involve counterparty risk:

1. Business and trade, including receivables and payables through financial intermediaries,

2. Trade guarantees and short-term lending, including letters of credit, banker’s acceptances, unfunded commitments, and revolving credit lines,

3. Repurchase agreements and reverse repurchase agreements, as well as securities lending arrangements, and

4. Derivatives, including currency forwards, interest rate swaps, asset swaps, credit default swaps, total return swaps and options on swaps.

IMPORTANCE OF COUNTERPARTY RISK

Historically, credit management at corporations has focused mainly on customer risk from new and existing customers. Traditionally, analysis done in credit departments has centred on the question: “If we extend credit (or lease terms) to this customer, will they pay us back?” After all, depending on the industry and type of exposure, if one of the largest customers goes bankrupt, their supplier could easily follow suit. However, a prudent corporation should consider risks from a broader range of counterparties beyond its customers.

Traditionally, credit risk management has not been a core activity of companies outside the banking and financial services sector. The implication of not regularly managing and measuring credit risk can be substantial and potentially lead to harmful debt exposure, supply chain disruptions, reputational risk, and hefty legal fees incurred enforcing customer contracts. The global financial crisis has reinforced the importance of adequate risk management, including dealing with exposure to counterparties. The most important lesson from the situation is that most investors in the affected markets experienced minimal downside, provided they had proper counterparty risk management practices.

DIFFERENCE BETWEEN COUNTERPARTY RISK AND CREDIT RISK

There are five significant differences between counterparty risk and credit risk. 

1. Counterparty risk arises from the inability or failure to make a payment, but the amount of exposure is not predetermined. Credit risk is the possibility of loss on account of default due to the inability or unwillingness to meet its liability. In this case, the amount of loss is predetermined.

2. Counterparty risk is most relevant in derivatives markets, especially OTC trades, while credit risk is relevant in loans and advances banks and financial institutions give. 

3. Counterparty risk is a subset of credit risk because credit risk includes counterparty risk. 

4. Counterparty risk exposures vary based on the Mark-to-Market (MTM) position on the default date. In contrast, credit risk exposure is mainly predetermined and does not vary.  

5. Counterparty risk is bilateral because each party in a derivative transaction risks the other. In the case of credit risk, only one party (the creditor) has lending risk. The contract value of counterparty risk can be positive or negative.

DIFFERENCE BETWEEN COUNTERPARTY RISK AND DEFAULT RISK

What happens when a financial counterparty defaults on contractual obligations, i.e., it stops paying out what it turned out to be owing to the other counterparty? Counterparty risk is the potential loss that results from a counterparty to a derivative contract (specifically a forward contract or swap) unfulfilling its obligations towards the other party. 

Counterparty is the risk of loss that arises from a counterparty’s failure to perform. Contrary to default risk, due to a failure to repay a credit obligation, counterparty risk comes into play from a failure to honour commitments on a contract, as in the case of an in-the-money swap or option position.

FORMS OF COUNTERPARTY RISK

There are two forms of counterparty risk: pre-settlement risk and settlement risk.

Pre-settlement Risk 

Pre-settlement risk is the risk that a counterparty will default before the contract’s expiration date, i.e., before the final settlement of the transaction.

Settlement Risk 

Settlement risk is the risk of counterparty risk during the settlement process. It arises because the parties to a transaction, such as a forward contract, do not execute or perform their obligations simultaneously. For example, there may be a delay in delivering collateral or the contract’s instrument.

QUANTIFICATION OF COUNTERPARTY RISK

Methods used to mitigate or manage risks are not 100% effective. They cannot eradicate the risk. Therefore, it is crucial for an institution to correctly quantify the remaining counterparty risk and ensure that compensation is commensurate with the level of risk.

Generally, there are three levels at which counterparty risk can be quantified:

1. Trade level: where all the characteristics of the trade and associated risk factors are considered, 

2. Counterparty level: where risk mitigants such as netting and collateralisation are considered for each party, and

3. Portfolio level: where overall counterparty risk is considered while simultaneously recognising that only a small percentage of the counterparties will default.

INSTITUTIONS THAT TAKE SIGNIFICANT COUNTERPARTY RISK

Institutions that take significant counterparty risk can be categorised into three classes:

1. Large Derivatives Players

These are typically large banks with high numbers of derivatives on their books. They often trade with each other but have many clients from different sectors within the financial industry. 

2. Medium Derivatives Players

These are typically smaller banks, hedge funds, and pension funds. Players in this category trade with a relatively large number of clients. They are active in a large derivatives market. Also, they may not always post collateral against positions.

3. Small Derivatives Players

Small derivatives players include small financial institutions, large corporates, or sovereign entities with significant derivatives requirements. They have a few derivatives trades on their books and a relatively small number of counterparties. For example, they may be looking to hedge their investments.

HOW TO MITIGATE COUNTERPARTY RISK

It is worthwhile to see how large institutional investors and banks cope with counterparty risk to address this question. Banks are active players in the over-the-counter (OTC) market; hence banks are exposed to counterparty risk. Hedging counterparty risk is relatively easy to achieve, and OTC market participants have succeeded. Over-the-counters (OTCs) are bespoke contracts traded off-exchange with specific conditions determined and agreed upon by the buyer and seller (counterparties). Conversely, OTC derivatives are more illiquid as they are traded out of clearinghouses or exchanges, exposing the transactions to increased credit (default) risk. Examples of OTC are Interest rate derivatives, Credit derivatives, Commodity derivatives, equity derivatives, forward contracts, and swaps.

STRATEGIES USED BY BANKS TO MITIGATE COUNTERPARTY RISKS

Strategies adopted by banks to minimise counterparty risks include hedging, trading with selected counterparties, closeout netting, collateralised transactions, pro-rate sharing of security, guarantees as credit protection, capital conservation buffer, diversification, and shifting from bilateral trades to centralised trades.

BENEFITS OF SOUND COUNTERPARTY RISK MANAGEMENT

If a company rigorously follows best practices in credit and counterparty risk management, it can achieve certain advantages, including:

1. Unifying the credit assessment practice by implementing repeatable processes and standardising outputs,

2. Qualifying new customers quickly, reducing response time, and improving customer satisfaction,

3. Developing a more balanced portfolio of counterparties to withstand any downturns,

4. Receiving early warning signals necessary for proactive exposure management,

5. Minimising costs in both lousy debt expense and legal expenses incurred to enforce contracts, and

6. Protecting your company’s assets on lease or credit terms to customers.

COUNTERPARTY RISK MANAGEMENT

Treasurers should avoid this becoming an administrative process; instead, it should be a risk management process. It will be important that counterparty risk can be monitored and reported continuously. Real-time access to exposure and market data is a prerequisite to recalculating the exposures frequently. Market volatility can change exposure values rapidly. A credit default SWAP protects against default. In the event of a default, the buyer will receive compensation. The spread (credit default swaps spread) is the (insurance) premium paid for the SWAP.

There are five major steps involved in protecting a firm from counterparty risk, including: (1) evaluating potential counterparty, (2) performing peer analysis, (3) determining a credit score, (4) setting credit limits and terms, and (5) monitoring exposures.

COUNTERPARTY RISK MANAGEMENT POLICY

A sound counterparty risk management policy should address the following:

1. Eligible counterparties for treasury transactions and acceptance criteria for new counterparties.

2. Eligible instruments and transactions.

3. Term and duration of transactions.

4. Variable maximum credit exposure limits based on credit standing.

5. Exposure measurement.

6. Responsibility and accountability.

7. Decision-making to provide an overall framework for staff decision-making, including treatment of breaches.

8. Key Performance Indicators (KPIs).

9. Reporting.

10. Continuous improvement.

See video on Counterparty Risk and Counterparty Risk Management: https://youtu.be/CVVoKtW3VJo