Managing Counterparty Risk in OTC Derivatives

by Amol Dhargalkar, Director of Corporate Advisory Services, Chatham Financial

Prior to early 2008, managing counterparty risk across derivatives was low on the list of factors that most firms considered in the hedging and risk management process. While always a discussion point, the fall of Bear Stearns, Lehman Brothers, AIG and subsequent bail-outs of a large swathe of the financial industry across the world has brought managing counterparty risk to the forefront of many hedging discussions. There are several ways to mitigate the risk of a single counterparty default, but the most appropriate strategy is largely dependent upon the individual firm’s policies and objectives. This article will discuss three common strategies used to manage counterparty risk, and provide a case study example of how one firm manages this risk.

There are several ways to mitigate the risk of a single counterparty default, but most appropriate strategy is largely dependant upon the individual firm's policies and objectives.

One way to mitigate single counterparty risk is to enter into collateral posting agreements with your counterparty. When your portfolio of transactions is an asset to you, your counterparty must post you cash (or cash equivalents) based upon a negotiated Credit Support Annex. While this is an extremely effective method, a number of complications arise in the collateral posting scenario. First, it is highly unlikely that any firm can command one-way posting; apart from some structured vehicle transactions, collateral posting is, at best, almost always a two-way proposition that also forces you to post collateral if your hedging positions become liabilities. Second, it is extremely rare that your counterparty will agree to post dollar-for-dollar cash collateral; typically, your counterparty will only post collateral once the value of the transactions has exceeded a certain level (Threshold), which may be so high as to render the collateral posting arrangement worthless.

An alternative manner of managing counterparty risk is to purchase insurance related to your hedge provider, ideally from a stable entity with a very high credit rating. These contracts, commonly referred to as credit default swaps (CDS), are priced in terms of annual cost to protect a given notional amount (e.g., 200bps notional amount per year) and reimburse the holder based on a percentage equal to the eventual recovery rate upon default (e.g., if the recovery rate is 30%, the insurance pays 70% of notional). The use of the credit default swap market to hedge counterparty risk can become cash intensive and complex to manage because the amount protected by the CDS is a function of assumed recovery rate which is impossible to predict in advance. Additionally, as conditions of your counterparty change over time so too does your level of exposure, which necessitates constant rebalancing of credit hedges and creates additional market risk associated with buying or selling the CDS.

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A far more common approach to managing counterparty risk is to craft internal processes that address the following four categories:

• Diversification of counterparties: Refrain from having only one or two potential hedging counterparties. While credit for derivatives may be difficult to obtain in the current environment, it is imperative to line up a broad set of counterparties. This also provides you with leverage on pricing and legal terms.

• Consistent negotiation of ISDA and CSA provisions: Before entering into a transaction with any counterparty, make sure that you’ve negotiated market standard provisions for items such as collateral posting (if necessary), and calculation methodologies in the event of a default. Specifically, use of a 1992 ISDA may provide you with more flexibility in the event of a counterparty default, particularly if you specify Market Quotation as the method used to determine the termination value. Many firms that had transactions in place with Lehman were able to benefit economically in their termination value methodology because of the provisions negotiated within their ISDA agreements.

• Periodic counterparty credit review: At least quarterly (maybe monthly), keep track of what is happening with your existing and potential future counterparties. Review not only the value of your positions, but also your counterparties’ standing in the market by reviewing their borrowing spreads, CDS, financial statements and any other indicators about their access to liquidity.

• Active disaster management: If you are concerned about one of your counterparties, be sure to have plans in place for replacement or termination of the transactions. If your positions are liabilities, you may want to consider doing nothing but simply monitoring the financial health of your counterparty.

As the Lehman bankruptcy has shown the market, one can never be prepared for all  the ripple effects of a large dealer default. At a minimum, though, all users of OTC derivatives should focus on being able to manage at least the first-order effects on their organisations through prudent risk management processes. Our experience has shown that those who create clear policies and execute them consistently in all markets have far more successful hedging programmes in the long term.