Counterparty Risk: Definition & Guide to Managing the Risks

counterparty risk

One of the most important lessons from the financial crisis a decade ago was that the financial world we lived in was not as secure as we imagined. Despite recent industry and government attempts to strengthen the financial system, this statement remains valid today.
We discovered an enhanced knowledge of counterparty risk management in credit discussions with corporate cash investors. In this essay, we aim to explain counterparty risk from the perspective of a corporate treasurer, why it has grown increasingly difficult to track and manage, and the main concepts of managing this risk.

What Is Counterparty Risk?

The risk that a contracting party may fail to fulfill its contractual obligations is referred to as counterparty risk. It is essentially a type of indirect credit risk, as opposed to the direct risk associated with unsecured borrowings such as bonds and deposits.

In an interest rate swap transaction with an investment bank, for example, the investor may not earn from a winning contract if the bank goes insolvent before the contractual date, rendering the arrangement worthless. Asset collateral, margin balances, and third-party guarantees may safeguard against counterparty risk in particular transactions, but such support mechanisms may also add new dimensions to counterparty risk.

Credit default swaps, a typical derivative with counterparty risk, are frequently exchanged with another party rather than on a centralized exchange. Because the contract is directly related to the other party, there is a higher risk of counterparty default because neither side is fully aware of the other’s financial health (and their ability to cover obligations). This is distinct from products that are listed on an exchange. In this scenario, the counterparty is the exchange, not the single firm on the other side of the trade.

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This risk became more visible in the aftermath of the global financial crisis. AIG was well-known for using its AAA credit rating to sell (write) credit default swaps (CDS) to counterparties seeking default protection (in many cases, on CDO tranches). When AIG was unable to post further collateral and was forced to give funds to counterparties due to deteriorating reference obligations, the United States government bailed them out.

Regulators were concerned that AIG’s defaults would reverberate through the counterparty chains, resulting in a systemic disaster. Not only were individual firm exposures at stake, but so was the risk that interwoven linkages via derivative contracts would jeopardize the entire system.

Risk Premiums and Counterparty Risk

If one side is more likely to default than the other, a premium is frequently added to the transaction to compensate the other party. A risk premium is a premium added as a result of counterparty risk.

Credit reports are frequently used by creditors in retail and commercial financial transactions to assess the credit risk of the counterparty. Borrowers’ credit scores are assessed and tracked to determine the level of risk to the creditor. A credit score is a numerical value that represents an individual’s or company’s creditworthiness and is based on a variety of factors.

A person’s credit score varies from 300 to 850, and the higher the score, the more financially trustworthy a person is regarded by the creditor. The following are the numerical values of credit scores:

  • Excellent: 750 and up
  • Good: 700–749
  • Fair: 650–699
  • Poor: 550–649
  • Poor: 550 and lower
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A client’s payment history, the total amount of debt, length of credit history, and credit utilization, which is the proportion of a borrower’s total available credit that is presently being utilized, are all elements that influence a credit score. The numerical value of a borrower’s credit score shows the lender’s or creditor’s counterparty risk. A borrower with a credit score of 750 would be considered to have low counterparty risk, whereas a borrower with a credit score of 450 would be considered to have a high one.

Due to the risk of debt default, the creditor will most likely charge a higher interest rate or premium if the borrower has a low credit score. Credit card issuers, for example, charge interest rates in excess of 20% for consumers with poor credit while offering 0% interest for clients with excellent or high credit ratings. If the borrower is 60 days or more late on payments or exceeds the card’s credit limit, credit card firms normally throw on a risk premium or “penalty rate,” which can boost the card’s annual interest rate to more than 29 percent.

Transaction Types Involving Counterparty Risk

Some common transactions that may include counterparty risk are listed below:

  • Business and commerce, including receivables and payables via financial intermediaries
  • Short-term loans and trade assurances, such as letters of credit, banker’s acceptances, unfunded promises, and revolving credit lines
  • Repurchase and reverse buyback agreements, as well as securities lending arrangements, are all examples of repurchase agreements.
  • Currency forwards, interest rate swaps, asset swaps, credit default swaps, total return swaps, and options on swaps are all examples of derivatives.
  • Surety bonds, property and casualty insurance, maritime insurance, directors’ and officers’ liability insurance, and errors and omissions insurance are all examples of insurance policies.

Counterparty Risk in Investment

Counterparty risk exists in financial investment products such as stocks, options, bonds, and derivatives. Bonds are graded from AAA to junk bond status by rating organizations such as Moody’s and Standard and Poor’s to determine the level of counterparty risk. Bonds with a higher counterparty risk have a higher yield. When the risk is low, such as with money market funds, premiums or interest rates are low.

A corporation that sells junk bonds, for example, will have a high yield to compensate investors for the increased risk that the company may default on its commitments. A US Treasury bond, on the other hand, has low counterparty risk and is hence rated higher than corporate debt and junk bonds. However, because there is less risk of default, treasuries often pay a lower yield than corporate debt.

Counterparty Risk Examples

When a party’s counterparty risk is overestimated and they default, the resulting damage can be significant. The default of so many collateralized debt obligations (CDOs), for example, was a major cause of the 2008 real estate meltdown.

#1. Subprime Risk

Mortgages are securitized and backed by underlying assets to create CDOs for investment. Before the economic catastrophe, one of the primary faults of CDOs was that they comprised subprime and low-quality mortgages, despite the fact that the CDOs were assigned the same high-grade ratings as corporate debt.

Because funds are required to invest only in highly rated debt, CDOs’ excellent credit rating enabled them to receive institutional investment. The real estate bubble burst as borrowers began to fail on mortgage payments, leaving investors, banks, and reinsurers on the hook for large losses. The rating agencies took a lot of heat for the fall, which finally led to the financial market disaster that marked the 2007–2009 bear market.

#2. Insurance Risk and AIG

American International Group, also known as AIG, provides insurance for real estate, corporations, and individuals. During the financial crisis, the corporation required a rescue from the US government. Those insured by AIG were suddenly subjected to an increase in counterparty risk. As a result, in order to determine whether there is counterparty risk, investors must analyze the entity that issued the bond, stock, or insurance policy.

What Is the Importance of Counterparty Risk to Me?

Counterparty risk is prevalent in financial markets, and it affects all types of investors, both large and small. For example, when investing in bonds (or any other sort of loan), all investors assume some level of counterparty risk, particularly when investing in corporate bonds. Most fixed-income investors are aware of this and are making an informed decision to accept this additional credit risk in exchange for higher yields.

Large institutional investors are not immune to this risk. To hedge their market risk, this group of investors frequently employs equities put options, swaps, swaptions, and inflation-linked swaps. Almost the bulk of these transactions is carried out in the OTC market because the listed market does not have the necessary hedging instruments. (Investment) banks are taking the other side of the transaction in the OTC market.

As a result, by definition, most major institutional investors must deal with a high level of counterparty risk. As the collapse of Lehman Brothers demonstrated, apparent protection is meaningless in the event of a hedge provider default – unless you are prepared and know how to deal with this risk.

Is Counterparty Risk Increasing as a Result of Present Market Conditions?

Certainly, in recent months, there has been a significant increase in awareness of counterparty risk and risk in general. This risk has always existed, but it has only recently come to the attention of the broader public.

The current widespread awareness of counterparty risk is exemplified by drastically increasing credit spreads, downward credit rating changes, and an increase in the number of bankruptcies and takeovers in the financial industry. To demonstrate, average credit spreads for banks (A- to AA+ rated) have risen from roughly 15bp in January 2007 to 200-500bp now (October 2008). This has resulted in a drop in the number of counterparties willing and able to take on the risk of institutional investors, as well as an increase in the likelihood that these parties will eventually fail on their obligations.

How Can I Reduce Counterparty Risk?

To find an answer to this topic, consider how huge institutional investors and banks deal with counterparty risk. As previously said, they are active participants in the OTC market, and counterparty risk is a daily occurrence for them. As we will see, hedging counterparty risk is actually pretty simple, and OTC market participants have had great success with it.

A structured approach to counterparty risk has proven to be the most effective, and it consists of three steps: counterparty selection, documentation, and collateral management.

The first step is to choose a set of counterparties. A thorough evaluation of potential counterparties based on a variety of variables, such as credit rating, credit spread, and experience trading a certain instrument (in other words, a sizable and active trading book), is typically necessary. Furthermore, the readiness to adopt counterparty risk-mitigation steps outlined in legal documentation can be essential in picking your counterparty.

Following the creation of a shortlist of plausible possible counterparties, International Swaps and Derivatives Association (ISDA) documentation must be created. This is the second step in the process. It is critical to have the proper paperwork in place for success.

Read Also: RISK ADJUSTED RETURN: Ratios, Formula, and Calculations

The ISDA paperwork is divided into three sections: the master, the schedule, and the credit support annexes (CSA). Each has a role to play in the overall process, but the CSA is the one that requires the most attention in the context of counterparty risk. The CSA establishes the regulations for collateral management, which is the Holy Grail of counterparty risk management. Parties can agree in the CSA on the levels of exposure collateral that must be posted (for example, the threshold amount and minimum transfer amount), the instruments to be used as collateral, the frequency of posting collateral, and so on.

Furthermore, parties can choose whether collateral must be physically transferred to an external investor’s account, as is common in European derivatives markets, or whether collateral remains with the counterparty under a pledge arrangement.

After the documentation has been completed and the transactions have been completed, the final stage is to carry out the collateral management itself. Drafting a CSA is one thing; executing on it and managing your collateral appropriately is quite another. The current market upheaval has demonstrated the importance of regularly monitoring and reporting on counterparty risk.

Banks and major institutional investors are both familiar with documentation and collateral management. In fact, high losses owing to counterparty risk are nearly often the result of inadequate paperwork and/or poor operational collateral management performance.

Conclusion

In contrast to a financed loan, the risk in a credit derivative is exacerbated by the fact that the value can swing negative or positive for either party to the bilateral contract. Counterparty risk methods evaluate current and future exposure, but Monte Carlo simulation is often required. Exposure to counterparty risk is produced by a successful in-the-money position. Potential future exposure (PFE) is used to assess the comparable credit exposure in a credit derivative, the same as the value at risk (VaR) is used to evaluate the market risk of a potential loss.

Counterparty Risk FAQs

What type of risk is counterparty risk?

A loan has default risk, but a derivative has counterparty risk. This risk is a category (or sub-class) of credit risk that refers to the risk of the counterparty defaulting in many types of derivative contracts.

What is the difference between credit risk and counterparty risk?

Credit risk is the risk of investing in a hazardous bond. The risk that the counterparty will be unable to meet its contractual commitments if a credit event occurs is referred to as counterparty risk.

How can counterparty risk be avoided?

Trading solely with high-quality counterparties with high credit ratings, such as AAA, is one of the most effective approaches to limiting counterparty risk. This will result in improved CRM and a reduction in the likelihood of future losses. Netting is another effective strategy for mitigating this risk.

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