How institutions manage counter-party risk

By Stephan Horan. This article originally appeared on on October 5th, 2008.

Investors are becoming increasingly concerned about the stability of financial companies. In the seventh of a monthly series, Stephen M. Horan discusses how institutions manage counterparty risk.

What is counterparty risk?

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 price of his corn falls, locking in his financial outcome.

In organised derivative securities exchange, a clearinghouse acts as an intermediary, serving as the counterparty to each side of a transaction and insuring performance if one party fails to perform on its contractual obligations. This arrangement allows investors to trade with confidence.

Why is a clearinghouse a less risky counterparty?

As an intermediary, the exchange-based clearinghouse has offsetting long and short positions managing its net exposure to the value of the contract to near zero. Its main exposure is that a party may default on their obligations. To protect against these losses, the clearinghouse monitors its member’s positions each day and collects small fees on each trade for capitalisation.

It also requires trading partners to meet certain capital requirements and to deposit funds to insure contract performance. As security prices fluctuate, counterparties are required to realise their losses on a daily basis or risk having their positions liquidated, a process called marked-to-market. This arrangement requires contracts to be standardised and actively traded so that clearinghouses have the necessary information to mark-to-market.

How is the over-the-counter (OTC) derivative market different?

In OTC markets, trades are negotiated between counterparties such as broker dealers, companies and hedge funds. The negotiation process allows parties to customise contracts, which prevents them from being traded on organised exchanges. Without a clearinghouse, counterparties assume each other’s credit risk. Many would suggest these differences mean there is really not a market, simply a series of private negotiations.

Assessing the risk of a particular counterparty is complicated by the opacity of their financial position. Although large financial institutions may publish quarterly or semi-annual financial statements, estimating the risk of their positions from that information is challenging.

How is counterparty risk related to the current financial market instability?

When a large party defaults, it can jeopardise the financial strength of their counterparties, which in turn increases the risk of default and so on. Because the notional value of derivatives markets dwarfs the cash markets (sometimes by more than 10 times), this cascade effect can cripple the financial system.

OTC derivatives markets absorb small idiosyncratic defaults quite well. The impact of major counterparty defaults is less clear. Lehman Brothers was a significant player in derivatives, but it was not one of the largest counterparties. AIG is one of the largest counterparties and was taken under the wing of the US Treasury out of fear for the systemic effects of a default.

How is counterparty risk managed without a clearinghouse?

Risk is managed by selecting and monitoring counterparties. Credit ratings are an important part of this monitoring process. Lehman Brothers was rated “A” just prior to bankruptcy, however. So ratings may be slow to capture sudden changes in financial health and are inadequate alone.

The fund manager must perform an independent credit risk analysis of their counterparties. Contracts often include procedures for requiring initial margin on trades and subsequent adjustments to margin as positions fluctuate, as well, similar to a clearinghouse but on a less frequent basis. Risk is also managed by limiting exposure to any single counterparty, diversifying credit exposure.

These measures are limited, however, in the face of a systemic collapse of confidence in capital markets.

Is it feasible to transition the OTC market to a clearinghouse model?

Much of the OTC derivatives markets is characterised by customised, illiquid contracts. This lack of standardisation is inconsistent with an actively traded market, and illiquidity makes it difficult to mark positions to market.

A dealer-based clearinghouse would require appropriate capitalisation and customised risk management techniques. Otherwise, risk may simply be transferred from individual dealers and concentrated in a single place at the clearinghouse. A more limited clearinghouse focusing on liquid and standardised derivatives could be a partial solution.

What are the implications for fund managers?

Current market failures may prompt more regulation, but OTC derivative contracts are a challenging instrument to regulate.

Fund managers trading OTC derivatives are well advised to approach counterparty risk management as rigorously as any other investment management activity. Those investing in financial services firms may take the opportunity to question management thoroughly and call for greater transparency.

Stephen M. Horan is head, professional education content and private wealth at CFA Institute. Greg Seals, director of fixed income and behavioural finance, contributed to this article.

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