Rules catch up with counterparty credit risks

Over the last 10 years, there has been a rapid growth in the number of counterparties engaged in derivative trading over the counter (OTC). In the initial years, a major proportion of such trading was executed only between regular interbank counterparties mostly under collateralised format. As the derivative markets evolved, there was also a gradual and growing participation from non investment grade corporate counterparties, majority of which had no collateral agreements. Till date, the increased trading businesses have led to trillions of dollars of total outstanding notional volume for derivatives.

For a bank, the counterparty credit exposure which arises out of derivative trades is slightly different from that originating from a typical loan transaction. In a derivative trade, there are two kinds of exposures, one of which is market-related and known as a trade exposure. The second exposure is related to the default risk of the counterparty.

In a simple loan transaction, we need to consider only the default risk-related exposure. Evidently, counterparty credit exposure for a derivative turns out to be relatively more complex and is often dependent on the non-trivial interplay between trade and default exposures. Although the trade exposure may not necessarily result into a default exposure, there could be a positive correlation between the two in some cases. An important part of the analysis of counterparty credit exposure involves how much is the impact of the correlation between the two.

A significant part of the derivative trades is undertaken by corporates for their general and specific hedging purposes. However, there are exceptions. For example, if an automobile company is exposed to higher interest rates in a derivative trade, counterparty credit risks are enhanced given the adverse impact of higher interest rates on the company’s financial health.

Similarly, if an importer is exposed to depreciation of local currency through derivative trades, the company is doubly impacted when the local currency weakens and its cost of input rises. Such derivative trades are termed as ‘wrong way risks’. These trades are often executed to monetise a specific market related view of the customer. It primarily involves asset classes like foreign exchange, interest rates and credit derivatives.

Spotting risks

Banks have developed an increased focus on identifying such trades in the last few years. Additional complexities arise in identification and analysis of such trades when we consider the entire counterparty portfolio with multiple trades which have netting and collateral agreements on top of them.

A new concept called ‘credit value adjustment’ (CVA) has been developed in recent years to account for any adverse impact of correlation between counterparty trade and default exposures in a derivative trade. CVA is a metric for the expected loss for a derivative trade and often known as credit charge. It is applied on a portfolio basis and imposes an incremental hurdle rate for a new trade.

Many banks incorporate CVA into individual trade pricing within a portfolio. CVA disincentivises any new trade which increases incremental wrong way risks on a portfolio basis. Higher pricing resulting from a higher CVA produces such disincentives and creates a risk adjusted return concept into derivative pricing. CVA is often managed by single or multiple desks within the bank organisation as an extension of front office. Although there is no specific method with which this desk operates across organisations, default risks are modelled from market implied rates wherever the same is available (e.g. credit default swaps). In cases where the market implied rates are not available, these default rates are determined on a proxy basis either from internal credit rating models or application of a spread over known or implied default rates for a specific industry or sector.

Many banks have invested significant sums of money into CVA infrastructure over past few years. These sophisticated systems are used to simulate trade and default exposures along with their correlations on a real time basis. They produce CVA pricing of any new trades in an automated fashion when asked for. The credit charges from these desks are sometimes explicitly used to buy protection on the counterparties. Otherwise, they may be used as a general reserve which gets released gradually as the trade runs off. However, given the complexities involved, the CVA pricing and hedging still continues to pose a significant technical and technological challenge to the banks.

As counterparty credit risks evolved, regulations on derivatives have been catching up fast with issues such as wrong way risks and CVA. In fact, some of these concepts have been at the heart of regulatory changes on derivatives in the recent past. Identification, monitoring, pricing and hedge management of wrong way risks in derivatives have constituted significant developments for most of the banks in response to the regulatory changes.

Stress tests

As part of a bank’s internal model method waiver application to the regulator, there has been an increased push to identify and manage wrong way risks in their portfolio. Banks are also scheduled to regularly perform market-related stress tests on significant trade exposures in their derivative books. Such model waivers incentivise banks to use their proprietary model implied credit exposures for derivatives (instead of standard or prescribed formulas) in order to optimise their capital calculations.

In 2009, Basel III introduced a proposal on new capital charge related to CVA volatility in form of CVA VaR (Value at Risk). There are two ways for banks to compute CVA VAR: standardised and advanced methods. The difference in capital charges could be very significant when compared across these two methods. One of the pre-conditions for a bank to be using advanced methods for CVA is to have an internal model method waiver in place. Finally, based on the fact that many banks are actively hedging CVA positions, Basel III recognises specific credit hedges (single name CDS, Contingent CDS and CDS indexes) for alleviating CVA volatility in capital measurements.

All of the above developments point towards a gradual evolution and management of counterparty credit exposures from its initial days. A global and coordinated approach between industry and regulators are being taken to unravel the complexities, encourage growth in the right directions and also safeguard against any widespread losses. We still have a fresh memory from the financial crisis in 2008-09. Given the tremendous sizes of the OTC derivative markets, significant downside possibilities always continue to remain in the not-so-distant horizon.

— The writer is a Dubai-based risk manager working for a reputed global bank. Views expressed are his own.