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An important concept is that financial risk is generally not reduced per se but is instead converted into different forms; for example, collateral can reduce counterparty risk but creates market, operational and legal risks. Often these forms are more benign, but this is not guaranteed. Furthermore, some financial risks can be seen as a combination of two or more underlying risks (for example, counterparty risk is primarily a combination of market and credit risk). Whilst this book is primarily about counterparty risk and related aspects such as funding, it is important to understand this in the context of other financial risks.

3.2.1 Market risk

Market risk arises from the (short-term) movement of market variables. It can be a linear risk, arising from an exposure to the movement of underlying quantities such as stock prices, interest rates, foreign exchange (FX) rates, commodity prices or credit spreads. Alternatively, it may be a non-linear risk arising from the exposure to market volatility or basis risk, as might arise in a hedged position. Market risk has been the most studied financial risk over the past two decades, with quantitative risk management techniques widely applied in its measurement and management. This was catalysed by some serious market risk-related losses in the 1990s (e.g. Barings Bank in 1995) and the subsequent amendments to the Basel I capital accord in 1995 that allowed financial institutions to use proprietary mathematical models to compute their capital requirements for market risk. Indeed, market risk has mainly driven the development of the value-at-risk (Section 3.3.1) approach to risk quantification.

Market risk can be eliminated by entering into an offsetting contract. However, unless this is done with the same counterparty12 as the original position(s), then counterparty risk will be generated. If the counterparties to offsetting contracts differ, and either counterparty fails, then the position is no longer neutral. Market risk therefore forms a component of counterparty risk. Additionally, the imbalance of collateral agreements and central clearing arrangements across the market creates a funding imbalance and leads to funding costs.

3.2.2 Credit risk

Credit risk is the risk that a debtor may be unable or unwilling to make a payment or fulfil contractual obligations. This is often known generically as default, although this term has slightly different meanings and impact depending on the jurisdiction involved. The default probability must be characterised fully throughout the lifetime of the exposure (e.g. swap maturity) and so too must the recovery value (or equivalently the loss given default). Less severe than default, it may also be relevant to consider deterioration in credit quality, which will lead to a mark-to-market loss (due to the increase in future default probability). In terms of counterparty risk, characterising the term structure of the counterparty’s default probability is a key aspect.

The credit risk of debt instruments depends primarily on default probability and the associated recovery value since the exposure is deterministic (e.g. the par value of a bond). However, for derivatives the exposure is uncertain and driven by the underlying market risk of the transactions. Counterparty risk is therefore seen as a combination of credit and market risk.

3.2.3 Operational and legal risk

Operational risk arises from people, systems and internal and external events. It includes human error (such as trade entry mistakes), failed processes (such as settlement of trades or posting collateral), model risk (inaccurate or inappropriately calibrated models), fraud (such as rogue traders), and legal risk (such as the inability to enforce legal agreements, for example those covering netting or collateral terms). Whilst some operational risk losses may be moderate and common (incorrectly booked trades, for example), the most significant losses are likely to be a result of highly improbable scenarios or even a “perfect storm” combination of events. Operational risk is therefore extremely hard to quantify, although quantitative techniques are increasingly being applied. Counterparty risk mitigation methods, such as collateralisation, inevitably give rise to operational risks.

Legal risk (defined as a particular form of operational risk by Basel II) is the risk of losses due to the assumed legal treatment not being upheld. This can be due to aspects such as incorrect documentation, counterparty fraud, mismanagement of contractual rights, or unanticipated decisions by courts. Mitigating financial risk generally gives rise to legal risk due to the mitigants being challenged in some way at a point where they come into force. Defaults are particularly problematic from this point of view, because they are relatively rare and very sensitive to the jurisdiction in question.

3.2.4 Liquidity risk

Liquidity risk is normally characterised in two forms. Asset liquidity risk represents the risk that a transaction cannot be executed at market prices, perhaps due to the size of the position and/or relative illiquidity of the underlying market. Funding liquidity risk refers to the inability to fund contractual payments or collateral requirements, potentially forcing an early liquidation of assets and crystallisation of losses. Since such losses may lead to further funding issues, funding liquidity risk can manifest itself via a “death spiral” caused by the negative feedback between losses and cash requirements. Reducing counterparty risk often comes at the potential cost of increased funding liquidity risk via mechanisms such as collateralisation or central clearing.

3.2.5 Integration of risk types

A particular weakness of financial risk management over the years has been the lack of focus on the integration of different risk types. It has been well known for many years that crises tend to involve a combination of different financial risks. Given the difficulty in quantifying and managing financial risks in isolation, it is not surprising that limited effort is given to integrating their treatment. As noted above, counterparty risk itself is already a combination of two different risk types, market and credit. Furthermore, the mitigation of counterparty risk can create other types of risk, such as liquidity and operational. It is important not to lose sight of counterparty risk as an intersection of many types of financial risk, and that mitigating counterparty risk creates even more financial risks. This is one of the reasons that this book, since the first and second editions, has evolved to cover more material in relation to collateral, funding and capital.

3.2.6 Counterparty risk

Counterparty risk is traditionally thought of as credit risk between OTC derivatives counterparties. Since the global financial crisis, the importance of OTC derivatives counterparty risk has been a key focus of regulation. Historically, many financial institutions limited their counterparty risk by trading only with the most sound counterparties. The size and scale of counterparty risk has always been important, but for many years has been obscured by the myth of the creditworthiness of the “too big to fail” institutions. However, the financial crisis showed that these are often the entities that represent the most counterparty risk. The need to consider counterparty risk in all OTC derivative relationships and the decline in credit quality generally has caused a meteoric rise in interest in and around the subject. Regulatory pressure has continued to fuel this interest. Whereas in the past, only a few large dealers invested heavily in assessed counterparty risk, it has rapidly become the problem of all financial institutions, big or small. At the same time, the assessment of the impact of collateral, funding and capital has become a key topic.