OTC Counterparty Risk Management Part 1

Think you’ve got world-class OTC counterparty risk management in place to protect your organisation or its clients from the next major derivative counterparty default?  Let’s find out.

Major derivative counterparties have defaulted before, and they will default again.  When the next counterparty fails, organisations with leading risk managers and practices will be well prepared, while others will sustain material write-downs and damage to their reputation.  Given the rapid changes in the management of counterparty risk post Lehman Brothers, it can be hard to know how well your organisation’s counterparty risk management program will perform.  Good management requires the legal agreements, systems, valuations, processes, measurement, and mandate compliance to be integrated.

There are many different approaches organisations take towards OTC counterparty risk, of which a few common ones are:

Asset Managers:

  1. “It’s the clients’ risk so we won’t do anything unless they specifically require it in the mandate.”
  2. “We don’t get paid to manage this risk as it’s not a performance driver.”
  3. “It’s too expensive and complicated to implement systems to manage that unlikely risk.”
  4. “We pay ratings agencies to cover that.”

Asset Owners

  1. “My Asset Manager chooses the counterparties, and I pay them to manage this risk for me.”
  2. “We don’t capture all the individual trades, so can’t really manage the risk.”
  3. “I’m sure we’re diversified enough so it won’t materially impact us.”

Before delving into the detailed set of questions, Figure 1 shows an overview of the general landscape surrounding OTC Counterparty Risk Management.  Each dimension of the landscape will be progressively explored, with Part 1 covering the setting of client risk appetite and establishing the counterparties.

The questions below are specifically for Over The Counter (OTC), non-centrally cleared derivative risks.  Additional articles will provide the rest of the questions and consider other risks of default.

Establishing Counterparty risk in the mandate (setting the risk appetite):

Asset Owner and Asset Manager

  • Who agrees counterparty risk management in the investment mandate (investment team? Committee? Risk Manager?)?
  • Are there requirements for a minimum credit rating for counterparties?
  • If external rating agency ratings are used, is it a ‘best of’, ‘worst of’, ‘median’, ‘latest’ or hierarchical approach to choosing the rating to be applied?
  • Is there a diversification limit (eg no more than x% of NAV to any single counterparty)?
  • Are definitions of exposure agreed and are there limits to monitor in the compliance system?
  • Do systems and processes exist to support the agreed risk management method?
  • Which ISDAs are being used – Asset Owner or Asset Manager?
  • Is there an Additional Termination Event specified in the ISDA to provide recourse in the event a counterparty is downgraded below a set threshold?
  • Does the threshold level in the Additional Termination Event align to minimum credit ratings specified in the mandate?

Asset Manager

  • If they are not our ISDA’s, do we have copies of them and can we comply with them?
  • What are the key parameters of the ISDA’s and is there a Credit Support Annex (CSA) to manage?

Asset Owner

  • If they are not our ISDAs; do we have a copies? are we comfortable with the provisions? Do they need to be reviewed by Legal?
  • If we use an external collateral management agent, can they comply with the ISDAs?
  • What reporting frequency and detail do we require from the Manager to aggregate with our other managers?

Establishing Counterparties

  • Does the client provide a list of approved counterparties?
  • How is counterparty approval managed internally?
  • Who has the final sign-off on a new counterparty?
  • If external ratings are used (SnP, Moody’s, Fitch etc) what extra due diligence is performed?
  • Is our contracting party the Ultimate Parent or a subsidiary in the legal structure?
  • Are there parent company guarantees in place?
  • How is a counterparty removed from the approved list?
  • Is the approved list of counterparties configured in the compliance system to prevent pre-trade & portfolio breaches?

By asking these questions you will align asset owner and asset manager expectations on the management of counterparty risk.  The answers to these questions will lay the foundation for systems, processes, methodologies, monitoring, and reports.  Read Part II for the questions to be asked on these components of OTC Counterparty Risk Management.

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