In bull markets it is easy to forget about counterparty credit risk, but recent turmoil has brought it to the fore and placed efficient management of such risk back on the agenda. Natasha de Terán reports.

During benign market conditions, counterparty credit risk is typically a forgotten risk – it only comes to the fore in times of market turmoil, deteriorating credit and scant liquidity. Yet, according to Shankar Mukherjee, managing director in Citigroup’s Counterparty Risk Group, counterparty credit risk is one of the fastest growing asset classes on Wall Street.

Not only that, but until recently dealers did not have a tool with which to directly mitigate it. Because of this they instead had to adopt conservative measures for their exposures and ended up with capacity constraints. But thanks to a new derivatives tool – the so-called contingent credit default swap (CCDS) – help may be at hand. For Mr Mukherjee, CCDSs offer the first real risk management mechanism to manage counterparty credit risk and, as such, should allow banks to manage it far more precisely.

Credit risk management

In recent years banks have become more focused on measuring and managing counterparty credit risk. Previously, counterparty credit risks simply accrued on the balance sheet, leaving banks with the luxury of sitting through periods of volatility. But now (especially for US banks adopting Fair Value accounting for the credit valuation adjustment – CVA – under FAS 157) these exposures are being marked to market.

As a result, risk groups are now generally much more aware of the magnitude of these exposures and encouraged to manage counterparty risk much more proactively. Over the past couple of years, Mr Mukherjee says many of the more sophisticated larger firms have started using CCDSs quite aggressively to do so; once the same accounting treatment is applied outside the US, he believes other banks are likely to follow.

There are other structural reasons that Mr Mukherjee believes bode well for the future of CCDSs. For instance, the fact that the current credit crunch has resulted in loan assets and conduit liabilities coming on to already swollen balance sheets, the massive growth of the over-the-counter (OTC) market and related exposures, and the introduction of Basel II. “It is the confluence of these factors that will encourage counterparty credit risk groups to use these instruments,” he says.

The fact that corporates, many of which are non-investment grade, are increasingly using derivatives and generally prefer not to sign control self-assessments (CSAs), means that a growing proportion of banks’ risk exposures are neither investment grade nor collateralised. Mr Mukherjee believes this can only further encourage banks to use CCDSs.

William Mertens, head of contingent credit derivatives at Icap, agrees. He says that if a bank wants to hedge its entire credit exposure to a particular market segment – say to European sovereigns or or US autos, it could do so through tailored CCDS contracts. “Equally, banks could do portfolio trades of SME exposures through CCDSs – thereby using the instruments to transfer such credit risk concentrations off their books for the first time,” he adds.

In the regulators’ hands

It is Basel II and the supervisors’ interpretation of CCDSs that could prove most pivotal in the instrument’s future. The rise in the number of long-dated OTC derivatives deals that banks have with lower rated counterparts has given rise to the sort of exposures that stand to be affected by Basel II’s treatment of counterparty credit risk. Mr Mukherjee and others hope that CCDSs will be able to alleviate some of this pressure.

Mr Mertens is even more confident. He says that CCDSs should already permit banks to optimise their regulatory capital, as buying protection through an external trade allows traders to effectively transform regulatory capital charges into trading book risk, thereby becoming eligible for regulatory capital relief. However, he adds: “While regulatory capital relief for the use of CCDSs is implicit and unquestionable to me, many players are still waiting for a definitive statement from their respective banking regulators.”

To this end, bankers and brokers have already been in discussions with US regulators and hope that when Basel II rules are published in the US in the autumn, CCDSs will definitively be permitted as valid hedges for counterparty credit risk and regulatory capital. In Europe they have also been in discussions with the UK’s Financial Services Authority and other EU regulators in the hope that they will follow suit.

In all likelihood the US and EU bodies will toe the same line on the treatment of CCDS, because one of the things the regulators have been most concerned about is international regulatory capital arbitrage – and any difference between the North American and European treatment of the instruments could give rise to this.

The fit

One of the oddities about CCDSs is that there is in a sense no obvious fit for the products within a bank. Some dealers have opted to manage their activity from their credit trading and sales desks; others from their risk management groups. Irrespective of this, Mr Mukherjee believes CCDSs fit well into a capital markets business as that is where risks are originated and distributed. “In this case they simply allow us to decompose a different risk – counterparty credit risk – into a replicating portfolio of simple plain vanilla OTC derivative positions which can then be redistributed to the wider capital markets,” he says.

At Citigroup, the set-up is as follows: the Credit Risk Management unit is responsible for CCDSs and works with the trading groups that originate the counterparty credit risks. It arrives at a decision as to whether the risk can be warehoused or needs to be hedged out. In the latter case, the risk is hedged out internally through a CCDS purchased from Citigroup Counterparty Risk, against the payment of an upfront premium. Citigroup Counterparty Risk then manages the CCDS risk – hedging it over the lifetime of the deal.

Such a sophisticated treatment of counterparty credit risk and the related cost allocation mechanisms are still rare, but Mr Mukherjee believes the whole market is headed in the same direction. “This will be a seismic change for those that originate the business. Some people don’t think about the risks of their counterparts, the duration of the trades and the costs involved. For instance, the banks that are under less pressure from an economic and regulatory capital perspective are less sensitive to this – but it is a question of when, not if, this will change. Then they will become more proactive in this area.”

The potential

For all of the uncertainty surrounding the regulatory interpretation of CCDSs, the evolving accounting treatment and the instruments’ low profile, the CCDS market is not new. It has in fact been in a slow state of development for the past four years. Mr Mertens says that trades are now occurring on a regular basis, but are still highly bespoke and sometimes take weeks to pull together.

More positively, he believes recent market disruption has newly motivated protection buyers in a way that the benign credit markets of the past couple of years did not. Over the past few months there was a clear negative correlation between rates and credit that was damaging to those holding leveraged loan swaps. As a result, Mr Mertens believes that many parties that previously thought the CCDS product was trading at too great a premium to model may no longer think so.

If that is good news for CCDSs’ prospects, the market remains divided about the product’s likely liquidity.

On the positive side, it is hoped that the CCDS will mirror the growth of the single name credit default swap (CDS) market. That was driven by loan portfolio managers who used the instrument to risk manage their books and, as the market expanded, a whole class of investors emerged to take the other side of the trades. Thus far, the limited size of the CCDS market and the pricing that is currently on offer means there is not yet an end investor group ready to take on the exposures and CCDS trading is still limited to dealers.

Wider appeal

Mr Mertens believes this is already changing. “Dealers have recently started to source protection from the buyside – so it’s not just a question of the dealers exchanging these credit risks between themselves, the risk is actually leaving Wall Street,” he says.

Marcus Schueler, managing director, integrated credit marketing at Deutsche Bank, is less confident. While he concedes that CCDSs are interesting products – particularly for counterparty credit risk groups – he says it can be difficult to find natural buyers, even within the dealer community. “Counterparty credit risk groups often have very much the same [trading interests] as other banks’ groups. It was only on the exceptional occasion that we found there was a natural fit.”

One of the principal problems Mr Schueler foresees in developing a market in CCDS products is that it is difficult to find trading counterparts with the same, very particular positions – counterparts that are willing not only to sell protection on particular names, but also to link that protection to very specific underlyings.

He says: “An additional complication is that the actual spread numbers are very small. If I am [inclined] to buy €1bn protection against a given name on a 10-year interest rate swap, the actual spread I will pay could be very small – perhaps as little as 2.5 basis points depending on the credit.” Because of these factors he believes the market will mostly attract counterparty credit risk groups rather than end investors.

It is too early to conclude whose prediction is correct, but even if Mr Schueler’s theory holds true and CCDSs remain the preserve of credit risk groups, the potential there is not to be scoffed at. Mr Mukherjee says that most banks with smaller derivative portfolios seem to know what the CVA is but they are not really focused on it yet.

When they are forced to do so – through the combination of Basel II and FAS 157 (or the IFRS equivalent) – there will be more of a strategic imperative for them to recycle regulatory capital and actively manage retained counterparty credit risk through the instruments.

THE CCDS INSTRUMENT

CCDS are in essence very similar to the standardised credit default swap (CDS) contracts that are the most widely traded instruments in the credit derivatives markets. But while the value of a CDS is dependent solely on the credit spread of a referenced name or obligor, the market value of the CCDS is dependent on both the credit spread of a referenced obligor and the expected positive exposure profile of a referenced derivative.

As in a CDS trade, on default of the referenced obligor, the seller of the CCDS pays the buyer the contract notional, which in the case of the CCDS is the market value of a referenced derivative transaction.

Therefore, just as a CDS enables the buyer to hedge against an increase in the credit risk premium of a bond or loan, a CCDS enables the buyer to hedge against an increase in the credit risk premium of a derivative contract.

The credit risk premium of a derivative contract is otherwise known as its credit value adjustment (CVA). The CVA is an adjustment made to the market value of a derivative contract to take into account the credit risk of the counterparty.

The buyer of the CCDS who hedges counterparty exposure reduces his overall economic risk because a deterioration of the credit quality of the underlying counterparty will result in an increase in the CVA and an increase in the market value of the CCDS, while an increase in the expected positive exposure profile of the underlying derivative will also result in an increase in the CVA and an increase the market value of the CCDS. Thus a CCDS enables protection buyers to hedge against increases in the CVA, whether those increases occur because of increases in the underlying obligor’s credit spread or because of increases in the expected exposure profile of the underlying derivative.

Derivative contracts typically referenced by CCDS contracts include plain vanilla swaps and simple derivatives, as well as other more complex structures.

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