Lecture 13 Derivative Contracts and Counterparty Risk Giampaolo Gabbi Financial Investments and Risk Management MSc in Finance 2016-2017
Agenda The counterparty risk Risk Measurement, Management and Reporting Market Practices and Conventions The link between counterparty, liquidity and operational risk The regulatory framework
Definition The risk to each party of a contract that the counterparty will not live up to its contractual obligations. Counterparty risk as a risk to both parties and should be considered when evaluating a contract. Because A is a counterparty to B and B is a counterparty to A both are exposed to this risk. For example if A agrees to lends funds to B up to a certain amount, there is an expectation that A will provide the cash, and B will pay those funds back. There is still the counterparty risk assumed by them both. B might default on the loan and not pay A back or B might stop providing the agreed upon funds.
General definition Classification of Counterparty Credit Risk Settlement Risk Pre-Settlement Risk Wrong-way risk Settlement Risk Risk that a counterparty defaults in the time when contractual payments are due whereby payments/deliveries to the counterparty already took place before value has been received.
General definition Pre-Settlement Risk is the sum of 2 components Current exposure Is the current replacement cost of a transaction It represents the amount that would be lost if the counterpart defaulted today. This amount equals the market value of a transaction on reporting date (mark-to-market). Potential exposure Is an estimate of the future replacement cost of transactions, the potential future increase of the market value as a result of fluctuations in for example interest rates, exchange rates or stock prices.
CCR for financial exposures by clearing models When transactions are collateralized, the clearing organization assumes the obligations under each derivative contract that has been accepted, thus minimizing the counterparty risk. In a clearing structure where the member clearing model is applied, the end-customer has a risk towards the member as the end-customers do not have a direct legal relationship with the clearing organization. In a clearing structure where the end-customer clearing model is applied, the end-customer has a limited counterparty risk towards the clearing member since the end-customer has a direct relationship with the clearing organization
CCR in funzione del modello di clearing
CCR in funzione del modello di clearing
Wrong-way risk. Definition Wrong-way risk is defined by the International Swaps and Derivatives Association (ISDA) as the risk that occurs when "exposure to a counterparty is adversely correlated with the credit quality of that counterparty". In short it arises when default risk and credit exposure increase together. The terms wrong-way risk' and wrong-way exposure' are often used interchangeably. Ordinarily in trading book credit risk measurement, the creditworthiness of the counterparty and the exposure of a transaction are measured and modelled independently. In a transaction where wrong-way risk may occur, however, this approach is simply not sufficient and ignores a significant source of potential loss.
Wrong-way risk. Definition Basel II highlighted the issue of wrong-way risk as an area which should be specifically addressed by banks in their risk management practice. In recent years however wrong-way risk has come more sharply into focus as an area of concern for risk managers and one that may have been neglected by many. There are a number of reasons for this. In part it is due to the advancements in credit derivative trading that bring creditworthiness into the trading book as a market factor. It also is due to the sub-prime crisis in 2007, the subsequent market volatility and the increasing attention being paid to credit risk. Whilst focusing on wrong-way risk, one should not forget that right way risk must surely be the normality in derivative markets
Wrong-way risk. Example As there are different degrees of correlation, so too there are different shades of wrong-way risk. Take the case where a bank buys an equity put option or enters into a reverse repo. If the counterparty and the underlying issuer are one and the same, these would be extreme cases of wrongway risk. Less obvious scenarios are where the counterparty and the underlying issuer are in a similar industry, or the same country or geographical region. Another example is the CDS on CDS seller.
Why is the CR important? Counterparty risk has been thrust into the spotlight since the fall of Lehman Brothers, causing the buyside to ramp up its risk controls, including increasing the frequency of margin calls, changes in types of collateral, and using more counterparties. Collateral management was mainly a matter for investment banks in the past, but the increasing use of derivatives for hedging or gain by asset managers and investors has made it an issue for the buy-side as well as the sell-side.
Why is the CR important? Since the crisis, financial institutions want independent valuations of their positions. So the choice is either to invest in big IT platforms and hire people or to rely on specialist providers. Philippe Rozental Head of asset servicing at Société Générale Prior to the crisis institutions were setting up derivative transactions and only calling the margin once a month. Now we are down to daily calls for collateral Staffan Ahlner Managing director of global collateral management at BNY Mellon
Why is the CR important? Lehman has increased the buy-side s awareness of counterparty risk. It is not enough for investors to sign a CSA (collateral security agreement); the collateralisation process has to be actively monitored and managed, which then puts a demand on firms [ ] Collateral management is becoming more complex and more time-consuming. If [asset managers] don t have infrastructure in place, buying technology is massively expensive. There is also a huge amount of pending legislation that will potentially change the whole marketplace Paul Wilson Global head of client management and sales for financing and markets products at JPMorgan Worldwide Securities Services
Why is the CR important? Therefore institutions are going to have to spend more money to keep operations, technology and processes in line with the future regulatory and best practices It s certainly going to be a big contributor in reducing risk in the marketplace but can also add a huge level of complexity for an asset manager who has multiple counterparties. Therefore you need to update your technology to deal with all those different scenarios. Counterparty risk Liquidity Operational risk
Some figures
Some figures The green line shows that the ratio of gross credit exposure to gross market value in the OTC derivatives market has fallen in recent years, notably so in 2008, consistent with an increase in bilateral netting. In addition, the red line shows that total collateral received (or, equivalently, total collateral posted) has risen relative to gross credit exposures, as rates of collateralisation of net positions have increased. Data on collateral used in the numerator of this ratio came from the International Swaps and Derivatives Association (ISDA), as ISDA calculates the amount of collateral on a different basis, whereby "collateral assets are counted twice, once as received and once as delivered".
Example Lenders withheld credit, fearing that borrowers might have significant claims on the investment bank that were not fully secure. Such claims could have arisen from bilateral derivatives trades in the over-the-counter (OTC) market, where total counterparty credit exposures vastly exceeded the total collateral posted by market participants. Since then, this gap has narrowed, reducing but perhaps not eliminating this particular systemic risk. The previous example discusses how to measure counterparty credit exposures across the OTC derivatives market
Example
Example Bilateral netting and collateralisation reduce counterparty credit exposures. Dealers A and B in the table are counterparties to an FX option that has a positive market value of 10 to B (and hence a negative market value of 10 to A). If A became bankrupt, B may never get to collect this value. B therefore has a counterparty credit exposure to A via the FX option of 10. To neutralise this counterparty risk, B could request collateral worth 10 from A, which it would retain if A defaulted on its contractual obligations. But A and B are also counterparties to a gold future, which has market value of +3 to A (and hence -3 to B). With a legally enforceable netting agreement, A and B could net market values over these two positions. This would compress the counterparty credit exposures between A and B to a single claim of B on A of 7. B would then only need collateral worth 7 from A to eliminate current counterparty credit exposures. Across all the positions in Table A, the sum of positive market values (or, equivalently, the sum of negative market values), known as the "gross market value", is 41. The sum of positive (or negative) market values after bilateral netting, known as the "gross credit exposure", is 17
Collateral and risk An average collateralisation rate of 100% does not ensure that all current counterparty exposures have been eliminated. This is because counterparty credit exposures are often over- or undercollateralised, as is the case for the positions in the example between Dealer A and the hedge fund and Dealer A and the non-financial corporation respectively. Firms may demand overcollateralisation to protect against losses on potential future counterparty credit exposures, which could be significantly larger than current exposures depending on how position values evolve. They may concede undercollateralisation if counterparties cannot easily source collateral or have low perceived default probabilities. A better measure of collateralisation than average rates is therefore to cap the collateral of any individual position at 100%. This would be equivalent to measuring the fraction of current counterparty credit exposures backed by collateral. Only a high value of this metric could generate confidence that there were no large uncollateralised counterparty credit exposures in the financial system.
Best practice Counterparty risk relating to derivatives is subject to prior specific credit approval which sets exposure limits for specific Group and external counterparties. Counterparty risk is measured and monitored by an independent risk management unit using, an internal model based on an historical (based on time series) simulation approach. This model is used to calculate with a 99% confidence interval the potential future exposure arising from OTC derivatives. The model takes into account the mitigation effect of the netting and collateral agreements entered into with various counterparties. Risky positions monitoring is performed through a system of internal limits which make difference among the following risks: pre-settlement risk for positions margined by collateral agreements; pre-settlement risk for positions not subject to collateral agreements; settlement risk.
Best practice Counterparty risk exposure is monitored in real time. The integration of front office and internal risk measurement systems enables continuous monitoring of changes in exposure due to derivatives. Wrong-way risk is addressed in a collateral policy. The policy states that securities issued by the counterparty or closely related entities must not be accepted as collateral. A regular reporting was implemented for all existing contracts with Rating Triggers to quantify the potential additional collateral/liquidity risk. The whole process of assessing counterparty credit risk, including the assignment of the internal rating and incorporation of guarantees provided, is documented in internal rules and regulations. Both the methodologies used to measure counterparty risk, as described above, and the underwriting process for setting limits on counterparty credit risk exposure is defined in specific policies. Counterparty credit risk is an integral part of the credit approval process.
Best practice Counterparty risk relating to derivatives is subject to prior specific credit approval which sets exposure limits for specific Group and external counterparties. Counterparty risk is measured and monitored by an independent Risk Management unit using an internal, Basel II compliant, model based on a Monte Carlo simulation approach which calculates potential future exposure on a daily basis for individual counterparties, countries and portfolios. The following are the main risk measures produced for counterparty presettlement risk: current exposure: the replacement cost that the bank would have to bear on default by the counterparty, given by the positive mark-to-market value of derivatives. potential future exposure: the future replacement cost arising from future increases in current exposure due to changes in risk factors (i.e. interest rates, exchange rates or share prices). Such component is calculated using Monte Carlo simulation based approach.
Best practice The Monte Carlo approach is used to calculate the main product classes potential pre-settlement risk exposure: OTC derivatives, such as currency derivatives, interest-rate derivatives, equity, credit and commodity derivatives as well as SFT transactions, such as (reverse) repurchase agreements or security lending. The Monte Carlo method in use includes the full revaluation of all transactions by present time buckets. The internal model is able to pick up the risk mitigation effect of the netting and collateral agreements and to provide exposure at default (EAD) and effective maturity (M) measures as prescribed under Basel II. Independent or threshold amounts, that are rating dependent, are avoided to be defined in collateral agreements. Therefore a rating downgrade would not require additional collateral to be provided.
Best practice Counterparty risk relating to derivatives is subject to prior specific credit approval which sets exposure limits for specific Group and external counterparties. Wrong-way risk is addressed in a collateral policy. The policy states that securities issued by the counterparties or closely related entities must not be accepted as collateral. At least annually Bank #2 quantifies the potential additional collateral/liquidity needs of the issued obbligazioni bancarie garantite in the event of a downgrade. The whole process of assessing counterparty credit risk, including the assignment of the internal rating and incorporation of guarantees provided, is documented in internal rules and regulations. Both the methodologies used to measure counterparty risk, and the underwriting process for setting limits on counterparty credit risk exposure is defined in specific policies. Counterparty credit risk is an integral part of the credit approval process.
Best practice In order to manage counterparty risk, exposures are modelled (and limits are set and monitored) based on the credit equivalent of the exposure. The weighting applied to the notional takes the specific riskiness of the product into account. Ongoing monitoring of positions is carried out to ensure that current exposures are within approved credit lines. Controls are as follows: 1. the amount of each credit line and the extent of usage are available in the front office system which is automatically updated through data downloads from the credit approval system and the front office system, with no intervention by traders; 2. prior check that a line of credit is available by front office staff (line control); 3. real time and ex-post control by credit approval staff (line control); 4. confirmation by middle and back office (line control) that new lines or renewals have been updated
Measuring the risk The stronger risk management practices which are developing to address these issues include: 1. Measuring and setting limits on the degree of reliance upon collateral to mitigate credit risk, while controlling the operational and legal risk associated with collateral; 2. Estimating current replacement cost and collateral value at potential liquidation (and buy-in) values, and not just current market prices; 3. Measuring the price worst case, using liquidation estimation techniques which reflect the potential for adverse price movements until a liquidation can occur (a VAR-type measure); as well as the potential impact liquidation might have on contract close-out and collateral valuations, either by applying judgmental stress tests or a liquidity adjusted VAR estimate which further extends time horizons;
Measuring the risk 4. Evaluating initial collateral determination and any unsecured credit limits in light of the results of potential liquidation analysis; 5. Estimating potential exposure based on a more realistic market model and reflecting risk reduction and risk mitigating arrangements, including the shorter timeframes these entail; 6. Performing stress test evaluations of counterparty credit exposures which evaluate the potential correlation between market risk factors and the credit quality of the counterparty; and 7. Establishing more comprehensive limit structures relating to (i) pre-collateral exposures; (ii) estimated liquidation exposures; and (iii) potential exposures.
Measuring the risk. Some indicators FI's should upgrade their ability to monitor and, as appropriate, set limits for various exposure measures including: Current Replacement Cost: measured at market to include the benefit of netting agreements if legally enforceable with high confidence but before consideration of any related collateral. Current Net of Collateral Exposure: measured as current replacement cost minus the net value of collateral in respect of which there is high confidence about enforceability and perfection of security interest. Current Liquidation Exposure: measured as current net of collateral exposure based upon estimates of liquidity-adjusted contract replacement cost, the liquidation value of collateral received and the buy-in cost of collateral pledged. Potential Exposure: measured on the basis of potential future market moves adjusted for collateral rights, threshold agreements, optional unwind rights, as well as the shorter timeframes these rights imply.
Reporting the CR The steps that might be taken to improve the quality and timeliness of information available to regulatory authorities on CR, two are the main objectives: The first is to suggest ways to facilitate the timely sharing of qualitative information on market conditions and trends, and not just quantitative information on recent firm specific performance and risk profile developments. This reflects the judgment that few, if any, standardized forms of regulatory reporting can anticipate emerging sources of significant potential market problems, let alone systemic risks. The second is to respond to the desire to facilitate regulatory monitoring of counterparty credit risk management developments, as they relate to the range of issues and subjects discussed in this report, with particular emphasis on issues of leverage and concentrations of risks.
Reporting the CR FI's with significant counterparty credit and/or market exposure should be prepared to meet informally with their primary regulator on a periodic basis to discuss their principal risks as well as market conditions and trends with potential market disruption or systemic effects. To be effective, such meetings should involve only a small number of senior officials from both sides. If requested by its primary regulator, FI's with significant counterparty credit exposures should voluntarily provide reports to that regulator detailing certain large exposure information on a consolidated group basis. A suggested uniform format, derived from suggested enhancements to senior management reporting, is provided for consideration. Regulatory agencies requesting such information should reach clear understandings with providing institutions on permissible uses of such information, arrangements for sharing and aggregating such information, and safeguards against its misuse.
Regulatory framework The Basel Committee engaged in a wide-ranging effort to ascertain areas where capital requirements for counterparty credit risk (CCR) need to be strengthened. The Committee considered: areas where the current treatment did not adequately capitalise for the risks during the crisis; the provision of incentives to move bi-lateral OTC derivative contracts to multilateral clearing through central counterparties; the provision of incentives to reduce operational risk arising from inadequate margining practices, back-testing and stress testing; and whether the changes would contribute to reducing procyclicality
Regulatory framework The Committee identified several areas where capital for CCR proved to be inadequate. Some of the concerns about the capital treatment of CCR have broader consequences and the resulting recommendations may, in some cases, affect areas outside of counterparty credit risk. During the recent market crisis, a key observation was that defaults and deteriorations in the creditworthiness of trading counterparties occured precisely at the time when market volatilities, and therefore counterparty exposures, were higher than usual. Thus, observed generalised wrong-way risk was not adequately incorporated into the framework
Regulatory framework Mark-to-market losses due to credit valuation adjustments (CVA) were not directly capitalised. Credit value adjustment (CVA) is by definition the difference between the riskfree portfolio value and the true portfolio value that takes into account the possibility of a counterparty s default. In other words, CVA is the market value of counterparty credit risk. Roughly two-thirds of CCR losses were due to CVA losses and only about onethird were due to actual defaults. The new regulatory framework addresses CCR as a default and credit migration risk, but does not fully account for market value losses short of default The close-out period for replacing trades with a counterparty with large netting sets or netting sets consisting of complex trades or illiquid collateral extended beyond the horizon required for the capital calculations Initial margining typically was very low at the start of the crisis and increased rapidly during the turmoil. This had a destabilising effect on many market participants and sometimes caused or precipitated defaults. Capital based on Effective expected positive exposure (EPE) did not provide sufficient incentive for adequate initial margins to be required at all points of the cycle
Regulatory framework To better capture CVA losses, the Committee also is proposing to implement the bond-equivalent of the counterparty exposure approach. In practice, this proposal provides a capital add-on by using a bond equivalent as a proxy for CVA risk. It covers the 99% worst case CVA profit and loss (P&L) as per the market risk framework as an addition to the existing treatment of default risk. Under the bond equivalent approach, single-name credit default swap (CDS) hedges that reference the counterparty to which the bank is exposed will be recognised.
Regulatory framework Treatment of mark-to-market counterparty risk losses In addition to the capital requirements for counterparty risk determined based on the standardised or internal ratingsbased (IRB) approaches for credit risk, a bank must calculate an additional capital charge to cover mark-to-market unexpected counterparty risk losses. This additional charge must be calculated by treating counterparty exposures as bond equivalents, and is determined by applying the applicable regulatory market risk charge to such bond-equivalents, after excluding the Incremental Risk Charge (IRC).
Regulatory framework The additional capital charge should be calculated as the stand-alone market risk charge (excluding IRC) for a set of bonds and associated hedges. In this set there is one bond per OTC derivative counterparty, and this bond has the following characteristics: Notional of the bond: the current total EAD of the counterparty across all its OTC derivative netting sets Maturity of the bond: Effective Maturity across OTC derivative netting sets with this counterparty Type of bond: zero-coupon Spread used to discount the bond-equivalent: The spread used to calculate the Credit Valuation Adjustment (CVA) of the counterparty
Regulatory framework This market risk charge consists of both general and specific risks, including Stressed VaR but excluding the IRC In applying this charge, both general interest rate and credit spread risks must be taken into account. If the firm has VaR approval for bonds then the charge should be calculated using the firm s authorised VaR model for such bonds. If not, the standardised general market risk charge should be used. The stress period to use for the Stressed VaR component of this market risk charge is the stress period that the firm uses for credit assets for market risk regulatory capital purposes. The liquidity horizon to use for this market risk charge is one year, instead of the 10-day horizon used for market risk capital purposes. If the firm s VaR model does not calculate the one-year VaR directly, and in the case of the standardised approach, this one-year liquidity horizon should be calculated by multiplying the 10-day market risk charge by 5 (the square root of 25).