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Counterparty credit risk (often known just as counterparty risk) is the risk that the entity with whom one has entered into a financial contract (the counterparty to the contract) will fail to fulfil their side of the contractual agreement (for example, if they default). Counterparty risk is typically defined as arising from two broad classes of financial products: OTC derivatives (e.g. interest rate swaps) and securities financial transactions (e.g. repos). The former category is the more significant due to the size and diversity of the OTC derivatives market (see Figure 3.1 in the last chapter) and the fact that a significant amount of risk is not collateralised. As has been shown in the market events of the last few years, counterparty risk is complex, with systemic traits and the potential to cause, catalyse or magnify serious disturbances in the financial markets.

4.1.1 Counterparty risk versus lending risk

Traditionally, credit risk can generally be thought of as lending risk. One party owes an amount to another party and may fail to pay some or all of this due to insolvency. This can apply to loans, bonds, mortgages, credit cards and so on. Lending risk is characterised by two key aspects:

• The notional amount at risk at any time during the lending period is usually known with a degree of certainty. Market variables such as interest rates will typically create only moderate uncertainty over the amount owed. For example, in buying a bond, the notional amount at risk for the life of the bond is close to par. A repayment mortgage will amortise over time (the notional drops due to the repayments) but one can predict with good accuracy the outstanding balance at some future date. A loan or credit card may have a certain maximum usage facility, which may reasonably be assumed fully drawn16 for the purpose of credit risk.

• Only one party takes lending risk. A bondholder takes considerable credit risk, but an issuer of a bond does not face a loss if the buyer of the bond defaults.17

With counterparty risk, as with all credit risk, the cause of a loss is the obligor being unable or unwilling to meet contractual obligations. However, two aspects differentiate contracts with counterparty risk from traditional credit risk:

• The value of the contract in the future is uncertain – in most cases significantly so. The MTM value of a derivative at a potential default date will be the net value of all future cashflows required under that contract. This future value can be positive or negative, and is typically highly uncertain (as seen from today).

• Since the value of the contract can be positive or negative, counterparty risk is typically bilateral. In other words, each counterparty in a derivatives transaction has risk to the other.

4.1.2 Settlement and pre-settlement risk

A derivatives portfolio contains a number of settlements equal to multiples of the total number of transactions; for example, a swap contract will have a number of settlement dates as cashflows are exchanged periodically. Counterparty risk is mainly associated with pre-settlement risk, which is the risk of default of the counterparty prior to expiration (settlement) of the contract. However, we should also consider settlement risk, which is the risk of counterparty default during the settlement process.

• Pre-settlement risk. This is the risk that a counterparty will default prior to the final settlement of the transaction (at expiration). This is what “counterparty risk” usually refers to.

• Settlement risk. This arises at settlement times due to timing differences between when each party performs on its obligations under the contract.

The difference between pre-settlement and settlement risk is illustrated in Figure 4.1.

Figure 4.1 Illustration of pre-settlement and settlement risk. Note that the settlement period is normally short (e.g., hours) but can be much longer in some cases.

Example

Suppose an institution enters into a forward FX contract to exchange €1m for $1.1m at a specified date in the future. The settlement risk exposes the institution to a substantial loss of $1.1m, which could arise if €1m was paid but the $1.1m was not received. However, this only occurs for a single day on expiry of the FX forward. This type of cross-currency settlement risk is sometimes called Herstatt risk (see box below). Pre-settlement risk (counterparty risk) exposes the institution to just the difference in market value between the dollar and Euro payments. If the foreign exchange rate moved from 1.1 to 1.15, this would translate into a loss of $50,000, but this could occur at any time during the life of the contract.

Unlike counterparty risk, settlement risk is characterised by a very large exposure – potentially, 100 % of the notional of the transaction. Whilst settlement risk gives rise to much larger exposures, default prior to expiration of the contract is substantially more likely than default at the settlement date. However, settlement risk can be more complex when there is a substantial delivery period (for example, as in a commodity contract where one may be required to settle in cash against receiving a physical commodity over a specified time period).

Whilst all derivatives technically have both settlement and pre-settlement risk, the balance between the two will be different depending on the contract. Spot contracts have mainly settlement risk whilst long-dated swaps have mainly pre-settlement (counterparty) risk. Furthermore, various types of netting (see Chapter 5) provide mitigation against settlement and pre-settlement risks.

Case study: Bankhaus Herstatt

A well-known example of settlement risk is the failure of a small German bank, Bankhaus Herstatt. On 26th June 1974, the firm defaulted but only after the close of the German interbank payments system (3:30pm local time). Some of Herstatt Bank’s counterparties had paid Deutschemarks to the bank during the day, believing they would receive US dollars later the same day in New York. However, it was only 10:30am in New York when Herstatt’s banking business was terminated, and consequently all outgoing US dollar payments from Herstatt’s account were suspended, leaving counterparties fully exposed.

Settlement risk is a major consideration in FX markets, where the settlement of a contract involves a payment of one currency against receiving the other. Most FX now goes through CLS18 and most securities settle DVP,19 but there are exceptions, such as cross-currency swaps, and settlement risk should be recognised in such cases.

Settlement risk typically occurs for only a small amount of time (often just days, or even hours). To measure the period of risk to a high degree of accuracy would mean taking into account the contractual payment dates, the time zones involved and the time it takes for the bank to perform its reconciliations across accounts in different currencies. Any failed trades should also continue to count against settlement exposure until the trade actually settles. Institutions typically set separate settlement risk limits and measure exposure against this limit rather than including settlement risk in the assessment of counterparty risk. It may be possible to mitigate settlement risk, for example by insisting on receiving cash before transferring securities.

Recent developments in collateral posting have the potential to increase currency settlement risk. The standard CSA (Section 6.4.6), the regulatory collateral requirements (Section 6.7) and central clearing mandate (Section 9.3.1) incentivise or require cash collateral posting in the currency of a transaction. These potentially create more settlement risk, and associated liquidity problems, as parties have to post and receive large cash payment in silos across multi-currency portfolios.

4.1.3 Mitigating counterparty risk

There are a number of ways of mitigating counterparty risk. Some are relatively simple contractual risk mitigants, whilst other methods are more complex and costly to implement. Obviously, no risk mitigant is perfect, and there will always be some residual counterparty risk, however small. Furthermore, quantifying this residual risk may be more complex and subjective. In addition to the residual counterparty risk, it is important to keep in mind that risk mitigants do not remove counterparty risk per se, but instead convert it into other forms of financial risk, some obvious examples being:

• Netting. Bilateral netting agreements (Section 5.2.4) allow cashflows to be offset and, in the event of default, for MTM values to be combined into a single net amount. However, this also creates legal riskw in cases where a netting agreement cannot be legally enforced in a particular jurisdiction and also exposes other creditors to more significant losses.

• Collateral. Collateral agreements (Section 6.2) specify the contractual posting of cash or securities against MTM losses. Taking collateral to minimise counterparty risk creates operational risk due to the necessary logistics involved and market risk, since exposure exists in the time taken to receive the relevant collateral amount. Collateralisation of counterparty risk also leads to liquidity risk, since the posting of collateral needs to be funded and collateral itself may have price and FX volatility. Aspects such as rehypothecation (reuse) and segregation of collateral are important considerations here (Section 6.4.2 and 6.4.3). Like netting, collateral also increases the losses of other creditors in a default scenario (Section 6.6.1).

• Other contractual clauses. Other features, such as resets or additional termination events (Section 5.5.2), aim to periodically reset MTM values or terminate transactions early. Like collateral, these can create operational and liquidity risks.

• Hedging. Hedging counterparty risk with instruments such as credit default swaps (CDSs) aims to protect against potential default events and adverse credit spread movements. Hedging creates operational risk and additional market risk through the mark-to-market (MTM) volatility of the hedging instruments. Taking certain types of collateral can create wrong-way risk (Chapter 17). Hedging may lead to systemic risk through feedback effects (see the statement from the Bank of England in Section 2.4).

• Central counterparties. Central counterparties (CCPs) guarantee the performance of transactions cleared through them and aim to be financially safe themselves through the collateral and other financial resources that they require from their members. CCPs act as intermediaries to centralise counterparty risk between market participants. Whilst offering advantages such as risk reduction and operational efficiencies, they require the centralisation of counterparty risk, significant collateralisation and mutualisation of losses. They can therefore potentially create operational and liquidity risks, and also systemic risk, since the failure of a central counterparty could amount to a significant systemic disturbance. This is discussed in more detail in Chapter 9.

Mitigation of counterparty risk is a double-edged sword. On the one hand, it may reduce existing counterparty risks and contribute to improving financial market stability. On the other hand, it may lead to a reduction in constraints such as capital requirements and credit limits, and therefore lead to a growth in volumes. Indeed, without risk mitigants such as netting and collateral, the OTC derivatives market would never have developed to the size it is today. Furthermore, risk mitigation should really be thought of as risk transfer, since new risks and underlying costs are generated.

Another way to see some of the risk conversion described above is in xVA terms. CVA may be reduced but another xVA component created. Indeed, later chapters of this book will discuss this conversion between xVA terms in detail. For now, some obvious examples are:

• Collateral. Creates FVA (due to the need to fund collateral posting) and ColVA (due to the optionality inherent in the collateral agreement).

• Termination clauses. Aspects such as early termination events (possibly linked to downgrade triggers) create MVA that has been exasperated due to regulatory requirements regarding liquidity buffers (Section 16.2.1).

• Central clearing and bilateral collateral rules. The requirement to post additional collateral in the form of initial margin creates MVA.

• Hedging. Hedging CVA for accounting purposes may create additional capital requirements and therefore increase KVA. On the other hand, reducing KVA may lead to greater CVA volatility (Section 18.3.8).

The above explains why it is critical to manage xVA centrally and make consistent decisions regarding pricing, valuation and risk mitigation so as to optimise aspects such as capital utilisation and achieve the maximum overall economic benefit.

4.1.4 Exposure and product type

The split of OTC derivatives by product type is shown in Figure 4.2. Interest rate products contribute the majority of the outstanding notional but this gives a somewhat misleading view of the importance of other asset classes, especially foreign exchange and credit default swaps. Whilst most foreign exchange products are short-dated, the long-dated nature and exchange of notional in cross-currency swaps means they have considerable counterparty risk. Credit default swaps not only have a large volatility component but also constitute significant “wrong-way risk” (discussed in detail in Chapter 17)

Figure 4.2 Split of OTC gross outstanding notional by product type as of June 2014.

The above can be seen when looking at the averaged response from banks on their CVA breakdown by asset class in Figure 4.3. Although interest rate products make up a significant proportion of the counterparty risk in the market (and indeed are most commonly used in practical examples), one must not underestimate the important (and sometimes more subtle) contributions from other products. It is also important to note that, while large global banks have exposure to all asset classes, smaller banks may have a more limited exposure (for example, mainly interest rate and FX products). End-users may also have limited exposure: for example, a corporate may use only interest rate and cross-currency swaps.

Figure 4.3 Split of CVA by asset class (average over all respondents).

Table 4.1 Comparison of the total notional outstanding and the market value of derivatives ($ trillions) for different asset classes as of December 2014.

* This is calculated as the sum of the absolute value of gross positive and gross negative market values, corrected for double counting.

Source: BIS.

A key aspect of derivatives products is that their exposure is substantially smaller than that of an equivalent loan or bond. Consider an interest rate swap as an example; this contract involves the exchange of floating against fixed coupons, and has no principal risk because only cashflows are exchanged. Furthermore, even the coupons are not fully at risk because, at coupon dates, only the difference in fixed and floating coupons or net payment will be exchanged. Comparing the actual total market of derivatives against the total notional amount outstanding therefore shows a significant reduction, as illustrated in Table 4.1. For example, the total market value of interest rate contracts is only 3.1 % of the total notional outstanding. It is the market value that is more relevant, since this is representative of the loss that is suffered in a default scenario and is the amount that has to be funded or collateralised.

4.1.5 Setups

Broadly speaking, there are two situations in which counterparty risk and related aspects such as funding, collateral and capital arise. The most obvious (Figure 4.4) would apply to an end-user using OTC derivatives for hedging purposes. Their overall portfolio will be typically directional (but not completely so, as mentioned below), since the general aim will be to offset economic exposures elsewhere. The result of this will be that MTM volatility will be significant and any associated collateral flows may vary substantially. Indeed, the fact that substantial collateral may be required over a short time horizon is one reason why many end-users do not enter into collateral agreements. Another implication of directional portfolios is that there may be less netting benefit available. In practice, an end-user will trade with a reasonable number of bank counterparties depending on the volume of their business and risk appetite.

Figure 4.4 Illustration of the classic end-user counterparty risk setup.

Figure 4.5 Illustration of the classic bank setup.

Another important feature is that end-users may hedge risks on a one-for-one basis; for example, the terms of a swap may be linked directly to those of bonds issued rather than the interest rate exposure being hedged more generically on a macro basis. End-users may find it problematic when unwinding transactions, since the original counterparty will not necessarily quote favourable terms. Furthermore, if they do execute offsetting transactions – for example, a supranational may execute receiver swaps to hedge their lending whilst also having payer swaps to hedge borrowing – the terms received will be less favourable than if they macro-hedged the overall risk. This is a consequence of hedging borrowing and lending on a one-to-one basis. For a similar reason, default situations will be problematic because an end-user may want to replace transactions on a one-for-one basis rather than macro-hedging their exposure to the defaulted counterparty. This will likely be more expensive and time-consuming.

For a bank, the classic counterparty risk situation is rather different (Figure 4.5). Banks will typically aim to run a relatively flat (i.e. hedged) book from a market risk perspective. This means that a transaction with a client will be hedged (either on a macro basis or one-for-one) with another market participant. This is likely to lead to a series of hedges through the interbank market, ending with another opposite exposure to another end-user. In this situation, the bank may have little or no MTM volatility or market risk. However, they do have counterparty risk to both counterparties A and B, because if either were to default it would leave market risk with respect to the other side of the trade.

Another important feature of this situation is that client transactions will often be uncollateralised, whereas the hedges will be collateralised (or centrally cleared). The counterparty risk problem exists mainly on the uncollateralised transactions (although there is still material risk on the hedges). Whilst the overall MTM is neutralised, this introduces an asymmetry in collateral flows that can be problematic. Dealers also suffer from the directional hedging needs of clients. For example, they may transact mainly receiver interest rate swaps with corporate clients. In a falling interest rate environment, the bank’s exposure will increase substantially and the hedges of these swaps will require significant collateral posting. Figure 4.5 is very important as a starting point for many different types of analysis and will be referred back to at several later points in this book.