What do People Mean by Counterparty Risk?

What do you think of when someone asks, “what’s our risk to [company x]?”

The difficulty in answering this question is that counterparty risk has many different:

  • meanings;
  • exposure types; and
  • management techniques.

So it’s important to understand how your organisation defines and manages counterparty risk and where there is scope for improvement.

Common approaches to defining and managing counterparty risk are:

  • Accept the risk of default or failure to provide service as “within appetite” or unable to be mitigated. This is often due to the perceived low likelihood of default events and is the equivalent to avoiding the question and ‘flying blind’.
  • Define it narrowly, to just “Cash at bank” or “OTC Unrealised Profit” and measure and manage this exposure. The downside of this approach is that if a major legal entity defaults your organisation will be exposed to considerably more than just that one source of exposure.
  • Define and manage it broadly by taking all sources of risk into account, managing the ones you can, and assessing impact and contingencies for the ones you can’t.

My early experience with Counterparty Risk was exclusively with bilateral Over The Counter (OTC) derivative contracts, though this definition expanded as the various relationships with the external legal entities became apparent.  As the breadth of exposure expands, the risk may be better described as Legal Entity Risk which reflects that an external legal entity, or group of legal entities may have many different types of relationships other than a traditional ‘Counterparty’.

A broadly defined approach to Legal Entity Risk is depicted in Figure 1 below.  The diagram is stylised to show the types of risk and relationships that could exist for an asset owner, and their asset managers.   Key features include:

  • Each service provider or counterparty relationship established by the asset owner or asset manager generates some type of exposure to the legal entity (orange arrows). The list of services and risk types for your organisation will be specific to the type of investments it makes.
  • Legal structures matter: many counterparties have established complex entity structures to manage tax and regulation, which can make it difficult to follow which entity your organisation has direct exposure to.

An asset owner may have direct and indirect exposure to the same entity, which makes aggregations and understanding netting of exposures important.

Counterparty risk

Such a broad topic warrants considerable attention from risk managers, starting with the organisational definition of counterparty risk.  Action to take:

  • If your organisation already has a definition and framework for measuring and managing counterparty risk, why not cross-check it against the possible risks identified in Figure 1? Is your definition and framework up to date?  Are there simple steps you can take to increase transparency into the more complex legal entity risks (eg listing all dependencies your organisation has with its largest provider)?
  • If your organisation is currently lacking a proper definition & framework, start by talking to investment people to see what they consider to be the main counterparty risk exposures. Ask the lawyers which legal entities they think pose the biggest threat to the organisation if they fail to honour their obligations.  Apply the 80/20 rule to find the highest impact and likelihood risks, then start to formulate your definition, measurement, and framework.

Later posts will begin a closer look at different dimensions of Legal Entity Risk, and how its management can be integrated more broadly into your organisation.

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