The dramatic market downturn has led to worries about counterparty credit risk. In the over-the-counter credit derivatives market, where bilateral deals are struck directly between trade counterparts, credit risk quality is paramount. Natasha de Terán reports on how the market is coping.

“Counterparty credit risk is an important risk – but it is one that banks have been in the business of managing for a long time,” says Arran Rowsell, a director in the credit trading group at Credit Suisse. He is correct, but it would be imprudent to presume that this experience will guarantee banks safe passage through the current downturn.

The financial markets are more complex and interlinked today than they ever have been and risk is concentrated between a smaller group of players. Since the last crisis, there has been a vast proliferation of highly engineered instruments and an attendant increase in the amount of bilateral exposure between banks due to the enormous growth of the over-the-counter (OTC) derivatives market.

Given that the current crisis is a credit-driven one, some considerable concerns have centred on the credit derivatives market. Banks have been using these OTC instruments for less than a decade, and the market has quickly grown from a standing start to in excess of $43,000bn.

Useful mechanism

The credit default swap (CDS) market has dramatically improved credit market liquidity and transparency, and been widely lauded as a useful mechanism for isolating and transferring credit risk. However, due to the bilateral nature of the instrument and the absence of any central clearing mechanism, there is a double credit risk exposure inherent within any CDS trade; traders face the risk of both the underlying reference entity defaulting and their trade counterpart defaulting.

If both the counterparty and the reference entity default, that is a significant issue, but it is not just this double default risk that needs to be considered, as Mr Rowsell says: “If the CDS counterparty becomes materially weaker or defaults, we obviously need to replace any protection – irrespective of any deterioration in the actual reference credit.”

Analysts at Barclays Capital (BarCap) recently undertook an extensive study to estimate the effects of a major counterparty’s default. Its conclusion was that – apart from anything else – this would immediately result in a significant repricing in credit. The bank’s analysis showed that the failure of a major counterparty that had $2000bn outstanding in credit derivatives, could trigger losses of $36bn-$47bn in the wider financial system, solely due to the immediate repricing of credit risk arising from its default.

Additional fallout

And there is more, as Arup Ghosh and Magdalena Malinowska of BarCap’s credit strategy group explain: “These losses are only estimates of those that would be crystallised by investors with exposure to the defaulting counterparty. But in addition to these there would also be large, potentially concentrated, mark-to-market losses that would result from a repricing of risk and would affect investors without direct exposure to the defaulting counterparty.”

Widely used netting mechanisms could reduce the estimated losses significantly. However, because data on netted exposures is hard to obtain, it is not included in the above calculations. In any event, there are a further three factors that could cause the realised losses to exceed the above estimates. First, although Mr Ghosh and Ms Malinowska assume full collateralisation of CDS trades in their estimate, in reality collateralisation is always imperfect. “At the point of last posting of collateral, there would be some mark-to-market positions that are not backed by collateral, and any losses on these positions would increase the loss from gap risk,” they say.

Second, there is forward margining. Any collateral posted with a defaulting counterparty as part of forward margining would be subject to a loss. This loss would amount to the value of the collateral, less the CDS recovery amounts.

Third – and the most worrying point – is the concern about the fallout from the default of a significant counterpart on the wider OTC markets. A default of a major counterparty would not be isolated to the CDS market, as Mr Ghosh and Ms Malinowska observe: it would cause a significant repricing in all OTC derivatives. “This implies that the other OTC contracts would also be vulnerable to large gap risk – and, given the enormous amounts outstanding of these derivatives, netted exposures could be large and therefore gap risk losses on other OTC derivatives could be significant,” they say.

The trade counterparts in the CDS market are banks and broker dealers, monoline insurers and hedge funds. Notwithstanding the considerable deterioration in all these entities’ financial strength in the past nine months, Mr Rowsell says that the market has continued to function very efficiently. “There is still both confidence and good liquidity,” he says.

Henrik Raber, co-head of credit flow sales and trading at UBS, concurs. “The credit crisis has not hurt the CDS market. If anything, the crisis has reaffirmed the strength of the product with rising volumes. Naturally, with the increased market volatility and investment losses, the focus on counterparty exposure has increased, but this has occurred across all OTC markets, not solely CDS,” he says.

Nonetheless, he agrees that if there was a further dramatic downturn or steep downgrades in the financial sector – or a perception that some were likely – focus on counterparty exposure in derivatives would increase. “In the most extreme case that could reduce liquidity, but currently the reverse is occurring: volumes are higher and, increasingly, traditional investors are using CDSs as an investment tool,” he says.

Boosting confidence

The current level of confidence can be put down to two important factors: the widespread use of collateralisation and netting techniques, and the central banks’ apparent determination to avoid a banking failure.

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Gareth Levington, managing director in the structured finance group at Moody’s in London, says: “Any CDS users that have been carefully pricing and monitoring their positions will have a good grip on their counterparty exposures and, if they have been hedging their books dynamically, they will also have bought protection on their counterparties to help limit volatility. I expect these are the majority.”

And in a conversation that pre-dated the US Federal Reserve’s recent move to exchange mortgage-backed and other securities for treasuries, and its subsequent provision of liquidity support to Bear Stearns, Mr Levington said he thought this could result in a future sea-change in the way in which investors sought out CDS trade counterparts. “My guess is that the market will distinguish considerably between the big universal banks, which in essence have the central banks standing behind them, and the broker dealers, which may not. Protection buyers will look to source protection from the universal banks rather than from the broker dealers.” Because the Fed’s mid-March move effectively provided a direct lifeline to the broker dealers, it could be surmised that the US central bank is – to all intents and purposes – also standing behind the broker dealers, and thus Mr Levington’s distinction between them and banks may have been eliminated.

CDS TRANSACTIONS In a credit default swap transaction, two counterparties agree to trade the credit risk of at least one third-party reference entity. The protection buyer pays a periodic fee to the protection seller in exchange for a contingent payment by the seller upon a credit event – normally the default or failure to pay of the reference entity. When a credit event is triggered, the protection seller either takes delivery of the defaulted bond or pays the protection buyer the difference between the par value and recovery value of the bond.

AN EXPANDING ARMOURYWhile the industry struggles to interpret the lay of the financial land, another tool could soon be pressed into widespread use to complement the current collateralisation and netting techniques. This is a new credit derivatives contract that is specifically designed to manage counterparty credit risk. The contingent credit default swap (CCDS) is a new form of CDS that allows market participants to directly hedge their OTC credit exposure. Unlike in a normal CDS, where the notional exposure (or risk) that is hedged is the credit risk in a bond or loan and is defined at the outset of the transaction, the exposure that is being hedged in a CCDS is the credit risk premium arising from another OTC trade. As such, the risk premium being hedged changes during the life of the transaction according to market movements in the underlying contract.The new instrument has already gained a following but  it is not yet widely used due to the lack of standardised documentation. This could soon change, however, as the project that has been under way to develop a swap-deliverable CCDS contract is understood to be nearing completion.A further possibility – albeit perhaps a more distant one due to the complexities of managing such a structure – is the emergence of a central counterparty (CCP) facility in which the counterparty credit risks would effectively be mutualised. All of the major exchanges, as well as independent clearing houses, have been studying how best they might implement such a mechanism, but for the moment the prospect remains a distant one.SettlementAnother area of unease has centred on the way in which CDSs settle. Because the CDS market has expanded so dramatically, the volume of derivatives contracts exceeds the underlying cash market – in some instances by a considerable factor. Traditionally, counterparties needed to effect physical settlement in default scenarios; however, as the CDS grew, the industry devised a cash-settlement protocol that eliminated the problem of protection buyers needing to get hold of and deliver bonds to their trade counterparts.Growing expectations of a rise in corporate default rates has left some observers wondering about the dependability of the CDS settlement procedure. The scheme has been tried, tested and found to work smoothly. But it has only been used on an ad hoc basis, in just nine credit events, in only one legal jurisdiction and never during a wave of defaults.

 

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Bob Pickel, chief executive of the International Swaps and Derivatives Association (ISDA), says: “The ISDA settlement mechanism has been successfully applied; it is very well tried and tested in US situations and is globally applicable.”

Bankers agree. Arran Rowsell, a director in the credit trading group at Credit Suisse, says that the current infrastructure could handle a series of defaults if unavoidable, not least because there is a lag between default and contract settlement. “We are very comfortable with ISDA leading the charge on this; the settlement protocol has been proven to work and there is no reason why the protocol cannot be expanded to include Europe.” Henrik Raber, co-head of credit flow sales and trading at UBS, says: “The dealers and the ISDA have spent a considerable amount of time to development the cash settlement protocol and as a result it has worked smoothly. It appears the majority are happy with the current process.”While the balance of industry opinion has been to wait to test-drive the mechanism during a non-US credit event, there have nonetheless recently been calls for the mechanism to be ‘hardwired’ into standard ISDA documentation for new trades. The loudest call came in mid-March when US Treasury secretary Henry Paulson was unveiling a set of recommendations from the President’s working group. In addition to recommending that the industry create a dedicated co-operative infrastructure embracing both trade processing and counterparty risk management tools, he said that the industry also should incorporate, without delay, cash settlement protocol into standard documentation. “We don’t need good ideas sitting on the shelf; we need good ideas put into practice,” he said.

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