Corporate failures caused
about by the financial crisis has brought to the fore an important topic i.e.,
counter party risk. In the GCC, credit risk is normally not strongly evaluated
due to lack of data. Also, there is a concentration of risk among major banks
which leads to spillover risk in case of failures. Absence of strong regulatory
structures in this area in GCC is a major impediment in handling this key risk
for investors. Also, due to weaker legal structures, enforcement of credit
rights is rendered more difficult in the GCC region. Following an earlier article in the
Financial Times (FTfm supplement) Mr. Raghu Mandagolathur, President of CFA
Kuwait and Stephen M. Horan, head of professional education content and private
wealth at CFA Institute discuss how institutions manage counterparty risk.
Q: What is
counterparty risk?
In derivatives contracts, parties agree to exchange cash
flows based on the price of an underlying assets. A corn farmer wishing to lock in the price he
receives for his crop, for example, may sell a futures contract that will pay
him more as the price of his corn falls, locking in his financial outcome. Counterparty risk is the risk that the hedger
or speculator, who buys the futures contract from the farmer, fails to pay if
the price of corn falls.
In organized derivative securities exchange, a clearinghouse
acts as an intermediary, serving as the counterparty to each side of a
transaction and insuring performance if one party fails to perform on its
contractual obligations. This arrangement
allows investors to trade with confidence.
Q: Why is a
clearinghouse a less risky counterparty?
As an intermediary, the exchange-based clearinghouse has
offsetting long and short positions managing its net exposure to the value of
the contract to near zero. Its main
exposure is that a party may default on their obligations. To protect against these losses, the
clearinghouse monitors its member’s positions each day and collects small fees
on each trade for capitalization.
It also requires trading partners to meet certain capital
requirements and to deposit funds to insure contract performance. As security prices fluctuate, counterparties
are required to realize their losses on a daily basis or risk having their
positions liquidated, a process called marked-to-market. This arrangement requires contracts to be
standardized and actively traded so that clearinghouses have the necessary
information to mark-to-market.
Q: How is the
over-the-counter (OTC) derivative market different?
In OTC markets, trades are negotiated between counterparties
such as broker dealers, corporations and hedge funds. The negotiation process allows parties to
customize contracts, which prevents them from being traded on organized
exchanges. Without a clearinghouse,
counterparties assume each other’s credit risk.
Many would suggest these differences mean there is really not a market,
simply a series of private negotiations.
Assessing the risk of a particular counterparty is
complicated by the opaqueness of their financial position. Although large financial institutions may
publish quarterly or semi-annual financial statements, estimating the risk of
their positions from that information is challenging.
Q: How is
counterparty risk related to the current financial market instability?
When a large party defaults, it can jeopardize the financial
strength of their counterparties, which in turn increases the risk that their
default and so on. Because the notional
value of derivatives markets dwarfs the cash markets (sometime by more than ten
times), this cascade effect can cripple the financial system.
OTC derivatives markets absorb small idiosyncratic defaults
quite well. The impact of major
counterparty defaults is less clear.
Lehman Brothers was a significant player in derivatives, but it was not
one of the largest counterparties. AIG
is one of the largest counterparties and was taken under the wing of the U.S.
Treasury out of fear for the systemic effects of a default.
Q: How is counterparty risk managed without a
clearinghouse?
Risk is managed by selecting and monitoring
counterparties. Credit ratings can be an
important part of this monitoring process.
Lehman Brothers was rated “A” just prior to bankruptcy, however. So ratings may be slow to capture sudden
changes in financial health and are inadequate alone.
The fund manager must perform an independent credit risk
analysis of their counterparties.
Contracts often include procedures for requiring initial margin on
trades and subsequent adjustments to margin as positions fluctuate, as well,
similar to a clearinghouse but on a less frequent basis. Risk is also managed by limiting exposure to
any single counterparty, diversifying credit exposure. These measures are limited, however, is the
face of a systemic collapse of confidence in capital markets.
Q: Is it feasible to transition the OTC market
to a clearinghouse model?
Much of the OTC derivatives markets is characterized by
customized, illiquid contracts. This
lack of standardization is inconsistent with an actively traded market, and
illiquidity makes it difficult to mark positions to market.
A dealer-based clearinghouse would require appropriate
capitalization and customized risk management techniques. Otherwise, risk may simply be transferred
from individual dealers and concentrated in a single place at the
clearinghouse. A more limited
clearinghouse focusing on liquid and standardized derivatives could be a
partial solution.
Current market failures may prompt more regulation, but OTC
derivative contracts are a challenging instrument to regulate. Fund managers trading OTC derivatives are
well advised to approach counterparty risk management as rigorously as any other
investment management activity, including an analysis of extreme scenarios on
counterparties’ risk profiles. Those
investing in financial services firms may take the opportunity to question
management thoroughly and call for greater transparency.
