OTC Counterparty Risk Management Part 2

One of the questions asked in Part 1 was “Are definitions of exposure agreed?”.  Misalignment between asset owner expectations, asset manager interpretations, and system capability may only become apparent after a counterparty has defaulted.  Proactive management is required.

Common Approaches to Exposure

The most common approach to determine exposure is to use the functionality available in trading and risk systems.  Functionality varies across systems, which may cause issues if an asset manager has a client with investments that span multiple asset class/risk systems (eg an equity investment where the manager uses FactSet, and a fixed income investment where the same manager uses BlackRock Aladdin).  The issue with this can be that inconsistent definitions of exposure may be used for the same risk type.

Consideration of counterparty risk exposure definition and systems should include the systems that the client and service providers’ use because a common system between entities will reduce reconciliation issues.

Other approaches include creating a bespoke system to manage counterparty risk across the organisation, consolidate all OTC derivatives into a single system, or to outsource some of the process (eg collateral management). 

The set of questions below will assist you in establishing a definition of exposure that meets stakeholder expectations and is supported by the systems and process.  Many of these questions are derived by integrating market risk management concepts to OTC counterparty risk management.

Measuring and Defining OTC Counterparty Risk Exposure

  • How do we define & measure OTC counterparty risk exposure?
    • Are systems in place to support the definition?
    • Do our exposure calculations consider the following legal parameters where required:
      • Credit Support Annex:
        • Minimum Transfer Amounts
        • Independent Amounts
        • Two-way collateral
        • Cash or non-cash collateral
        • Frequency of collateral payments
        • Net settlement of collateral
      • Valuation agent – if it is not us, we need to understand the counterparties’ valuations.
      • NAV decline triggers?
      • Cross-asset netting? (eg between equity & Fixed Income contracts)
    • Do we have the following dimensions covered?
      • Current Exposure: the maximum we could lose if the counterparty defaulted today, which is typically the unrealised PnL net of any collateral payments, with yesterday’s collateral call added back if not yet received.
      • Potential Exposure: how large our exposure could be based on potential market moves (using today’s portfolio position to the counterparty).
      • Stress Exposure: A type of Potential exposure that measures risk during a tail event.
      • Replacement risk: the cost & risk to re-create the exposure in the market after default.
      • Liquidity requirements from the exposure, both current, potential future, and during a stress event?
      • DV01 or Delta exposure to a counterparty?

Defining OTC counterparty risk exposure up-front, and confirming systems and processes exist to support it is critical in preparing your organisation for the next default.  Where relevant, the definitions should be shared with clients and service providers, so they understand how to measure OTC counterparty risk.  Part 3 will dive into monitoring and managing counterparty exposures.

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