INTRODUCTION

This chapter explores counterparty credit risk in depth. We first learn about OTC derivatives and why they are a source of counterparty credit risk. We then learn how counterparty credit risk is managed through collateral, netting, and central counterparties. This chapter also explores counterparty credit risk as a source of systemic risk.

After you read this chapter you will be able to:

• Describe derivative securities, including forwards, futures, options, and swaps.
• Understand the counterparty exposure associated with a derivative security.
• Explain the concepts of gross assets and net assets.
• Understand how collateral, netting, and central counterparties are used to manage counterparty credit risk.
• Distinguish between bilateral netting and multilateral netting.
• Understand why counterparty credit risk is perceived as a source of systemic risk.

OVERVIEW OF DERIVATIVE SECURITIES

A derivative security is an agreement between two counterparties to transact in the future in which the counterparties' profit or loss is a function of the value of an underlying asset. Derivative securities may trade on a derivatives exchange or through an over-the-counter (OTC) derivatives market. An OTC derivatives market is a market where trading takes place through networks of dealers that are employed by financial institutions, and does not take place on an exchange.

Broadly, there are three varieties of derivative securities:

• Forwards/futures
• Options
• Swaps

Let's briefly explore characteristics of each.¹

Forward/futures contracts: A forward contract or a futures contract is an agreement in which two counterparties agree to transact an underlying asset in the future for a price that is agreed upon at initiation. The “long” counterparty is obligated to purchase the underlying asset for a fixed price in the future from the “short” counterparty, which is obligated to sell. The expression “forward contract” is used when it trades OTC, and the expression “futures contract” is used when it trades on an exchange.

For example, two counterparties may enter into a futures contract in which the long counterparty agrees to purchase a share of IBM from the short counterparty for $160 in three months. If the value of a share of IBM is greater than $160 in three months, the long counterparty will profit as the long counterparty will pay only $160 for a stock worth more than $160. The short counterparty will suffer a loss as it is selling a stock worth more than $160 for only $160. However, if the value of a share of IBM is less than $160 in three months, the long counterparty will suffer a loss and the short counterparty will profit.

Option contracts: Like a forward/futures contract, an option contract is an agreement in which two counterparties agree to transact an underlying asset in the future for a price that is agreed upon at initiation. However, unlike a forward or futures contract, by an option contract one of the counterparties has the right and not the obligation to transact in the future. There are two varieties of option contract: call options and put options.

• By a call option, the long counterparty has the right—but not an obligation—to purchase the underlying asset for a fixed price in the future from the short counterparty. The short counterparty is obligated to sell. The long counterparty will only choose to exercise its right when it is in its best interest to do so. This ability to choose is valuable; hence the long counterparty must pay a premium at initiation to the short counterparty in order to obtain the right.
• By a put option, the long counterparty has the right—but not an obligation—to sell the underlying asset for a fixed price in the future to the short counterparty. The short counterparty is obligated to purchase. The long counterparty will only choose to exercise its right when it is in its best interest to do so. The long counterparty to a put option must pay a premium at initiation to the short counterparty in order to obtain its right.

For example, two counterparties may enter into a call option contract in which the long call has the right but not an obligation to purchase a share of IBM from the short call for $160 in three months. The long call pays the short call a premium of $25 in order to obtain this right. If the value of a share of IBM is greater than $160 in three months, the long call will choose to exercise their right to purchase, as they have the right to pay only $160 for a stock worth more than $160. However, if the value of a share of IBM is less than $160 in three months, the long call will not exercise its right.

The expression “OTC option contract” is used when an option trades OTC, and the expression “exchange-traded option contract” is used when an option trades on an exchange.

Swaps: A swap is an agreement between two counterparties to exchange cash flows over a number of periods of time in the future. While a wide variety of swaps are traded, the most commonly traded swaps are interest rate swaps, cross-currency swaps, and credit default swaps. Here's a brief description of each:

• Interest rate swap: Two counterparties agree to exchange a fixed rate of interest for a floating rate of interest over a number of periods of time. For example, the counterparties may agree to periodically exchange a fixed 3% for LIBOR over a five-year period of time.²
• Cross-currency swap: Two counterparties agree to exchange cash flows in distinct currencies over a number of periods of time. For example, the counterparties may agree to periodically exchange 3% of a specified amount of USD for 3.25% of a specified amount of euros over a five-year period of time.
• Credit default swap: One of the counterparties agrees to make periodic payments. In return, the second counterparty agrees to make a large payment to the first counterparty should a specified reference asset issued by a specified reference entity experience a credit event, such as a bankruptcy or a default. For example, one of the counterparties agrees to pay $10,000 per quarter for the next three years. In return, the second counterparty agrees to make a large payment should a specified IBM bond experience a credit event.

There are also swaps in which the counterparties agree to exchange cash flows based on the levels of equity indexes, commodity values, inflation levels, and volatility, among other varieties. Typically, both counterparties to a swap are obligated to make payments of cash flows. However, in some swaps, such as caps, floors, and swaptions, one of the counterparties has a right while the other counterparty has an obligation, similar to an option. Swaps trade through OTC derivative markets.

As we've seen, swap agreements typically specify a rate that is exchanged over a number of periods in the future, yet the actual transactions are exchanges of cashflows, not rates. To translate the rate specification into a dollar amount, each swap agreement will include a notional principal. Hence, the cashflows that are transacted are identified through multiplying the rates by the specified notional principal. For example, if a given rate is 3%, and the notional principal is $1 million, then the cashflow is 3% × $1,000,000 = $30,000. Typically, the notional principal is not exchanged, either at initiation or termination; hence its typical role is to translate rates into cashflows.³

COUNTERPARTY EXPOSURE

In the previous section we explored forwards, futures, options, and swaps. While these contracts vary widely, in all of them transactions will take place in the future at a price or a rate that is fixed today. Inevitably, this will be beneficial to one of the counterparties and detrimental to the other. For example, an interest rate swap counterparty that is paying a fixed rate of 3% and receiving LIBOR in return will profit if LIBOR rises above 3% and will suffer a loss if the reverse occurs.

Valuation techniques are used to value positions in derivative securities. Using these techniques, counterparties record the value of a given derivative security as either an asset or a liability. A position will be recorded as an asset if the present value of the cash inflows that it is expected to generate is greater than the present value of the cash outflows that it is expected to generate, and will be recorded as a liability if the reverse is true. Derivative securities are “zero-sum games” in which the value of the asset that one of the counterparties holds in relation to a given derivative security is exactly equal to the size of the liability that the other counterparty holds.

The counterparty to a given derivative security whose position is an asset—which we will refer to as the asset counterparty—faces counterparty exposure. After all, the value of derivative position that is an asset is only valuable if the other counterparty—the liability counterparty—satisfies its obligations per the agreement. Should the liability counterparty experience financial distress and be unable to satisfy its obligations, the asset counterparty will have to write down the value of its asset to reflect whatever recovery it expects to obtain from the financially distressed liability counterparty.

To explore further the nature of the assets and liabilities associated with derivatives, we can make a broad distinction between two types of agreements: those in which both counterparties are obligated to transact in the future, and those in which one of the counterparties has the right to transact in the future and the other counterparty has an obligation. Let's explore each in more detail.

Derivative security in which both counterparties are obligated to transact in the future: Forward contracts, futures contracts, interest rate swaps, cross-currency swaps, and credit default swaps are examples of derivative securities in which both counterparties are obligated to transact in the future. For all of these, the contract is structured at initiation such that the value of each of the counterparties' positions is neither an asset nor a liability. This is implemented through setting transaction prices or rates at a level designed to ensure the position is valued at zero, given the counterparties' expectations of drivers of the derivative security's value, such as the underlying asset's future prices or rates. Once the agreement is executed, the drivers of value will change and the position will become an asset for one of the counterparties and a liability to the other counterparty.

Derivative security in which one of the counterparties has the right to transact in the future and the other counterparty has an obligation: Call options, put options, and caps, floors, and swaptions are examples of derivative securities in which one of the counterparties has the right to transact in the future and the other counterparty has an obligation. Having the right—and not the obligation—to transact is valuable as the counterparty can transact when it is beneficial to do so and not transact when doing so is detrimental. Hence, the derivative security is always an asset for the counterparty with the right and is never a liability. Conversely, the other counterparty—the one that is obligated to transact should the counterparty with the right choose to exercise—will only find itself transacting when doing so benefits the counterparty with the right and, inevitably, is detrimental to the counterparty with the obligation. Hence, the derivative security is always a liability for the counterparty with the obligation and is never an asset.

We see that the derivative security is always an asset for the counterparty with the right and is always a liability for the counterparty with the obligation. So why does the counterparty with the obligation agree to participate? The answer is that the counterparty with the obligation receives a premium. The premium compensates the counterparty for accepting the obligation and is reflective of the value of the liability. Once the agreement is executed, the drivers of value will change and the position will become an increasingly larger or smaller asset for the counterparty with the right and an increasingly larger or smaller liability for the counterparty with the obligation.

Table 11.1 summarizes the two types of agreements and the associated assets and liabilities. Both counterparties to a derivative security in which both counterparties are obligated to transact in the future face potential counterparty credit risk, as both are potentially asset counterparties. Positions that hold rights also face potential counterparty credit risk, as they are always an asset counterparty. Conversely, counterparties with an obligation that is conditional on the other counterparty exercising a right do not face counterparty credit risk as they are exclusively a liability counterparty.

HOW COUNTERPARTY CREDIT RISK IS MANAGED

We've seen that counterparties to derivative securities face counterparty credit risk exposure. This exposure is managed in a number of ways, key among which are the following:

• Collateral
• Netting
• Central counterparties

Netting

Netting refers to the offsetting of positions. There are two types of netting: payment netting and closeout netting. Payment netting is the netting that occurs when two counterparties plan to transact cashflows with each other at a specific point in time: Rather than each counterparty making the agreed payment, the two payments are netted out and only a single payment is made. The benefit of payment netting is that it avoids situations whereby one of the counterparties to a deal satisfies its payment obligation while the other fails to do so.

For example, consider a swap in which counterparty A is required to make a $40,000 payment to counterparty B on December 15 while counterparty B is required to make a $30,000 payment to counterparty A on the same date as well. Instead of each of the two counterparties making the required payments, the two payments are netted out and the only payment that occurs is a $10,000 payment from counterparty A to counterparty B.

Closeout netting is a more sophisticated netting concept that occurs when one of the counterparties to an agreement experiences a termination event such as a bankruptcy. Upon the termination event, the gross assets and gross liabilities are identified across all agreements that the counterparties have entered into with each other. Then, the gross assets and gross liabilities across all of the agreements are netted out, resulting in net positions that are smaller than the gross positions. The smaller net positions mean that the counterparty has less counterparty credit risk exposure than the gross asset position might suggest.

For example, consider two counterparties, A and B, which have entered into four derivative securities agreements with each other. Table 11.2 lists the asset and liability positions for each of the counterparties. Counterparty A's gross assets are $80,000 while counterparty B's gross assets are $90,000. However, due to closeout netting, these gross asset amounts are not the two counterparties' counterparty exposure. Instead, through closeout netting each counterparty's gross assets are offset by their gross liabilities, and the net exposure is much lower. Counterparty A has $10,000 in net liabilities, and therefore is not exposed to counterparty B at all. Counterparty B has $10,000 in net assets. Should counterparty A experience financial distress, counterparty B's exposure is its $10,000 in net assets and not its $90,000 in gross assets. We see from this example that closeout netting can greatly reduce counterparty exposure.

Derivative Security Agreement	Counterparty A	Counterparty B
#1	$20,000 Asset	$20,000 Liability
#2	$60,000 Asset	$60,000 Liability
#3	$80,000 Liability	$80,000 Asset
#4	$10,000 Liability	$10,000 Asset
Gross assets	$80,000 Gross Assets	$90,000 Gross Assets
Gross liabilities	$90,000 Gross Liabilities	$80,000 Gross Liabilities
Net assets or liabilities	$10,000 Net Liabilities	$10,000 Net Assets

To further explore, consider another example. A marketplace consists of four counterparties: A, B, C, and D. Each of these counterparties holds multiple derivative securities against each other, and their gross assets against each of their counterparties are illustrated in Figure 11.1. In this figure, an arrow pointing toward an entity refers to the gross assets it holds against the given counterparty. For example, counterparty A holds 30 of gross assets against B, while counterparty B holds 20 of gross assets against A. Figure 11.2 illustrates the same example, this time from the perspective of net assets.

Table 11.3 lists the gross assets and liabilities positions for each of the counterparties. For example, counterparty A has gross assets against all counterparties of 80, and this represents A's exposure should all of A's counterparties experience financial distress. Conversely, the market has gross assets of 40 against A, and this represents the overall market's exposure to A's financial distress. Notably, the total gross assets across all counterparties across the entire market is 300.

	Counterparty A	Counterparty B	Counterparty C	Counterparty D	Market
Gross assets against A	NA	20	20	0	40
Gross assets against B	30	NA	5	50	80
Gross assets against C	50	10	NA	20	80
Gross assets against D	0	90	10	NA	100
Gross assets against all counterparties	80	120	35	70	300

Table 11.4 lists the net assets positions for each of the counterparties. For example, counterparty A has net assets against all counterparties of 50, and, assuming the market facilitates closeout netting, this represents A's exposure should all of A's counterparties experience financial distress. Conversely, all counterparties have zero net assets against A, indicating that no counterparty is exposed to A's financial distress. Most noteworthy is that the total net assets across all counterparties across the entire market is 95, less than one third of the 300 in exposure identified in Table 11.3. This reduction of counterparty exposure demonstrates the usefulness of closeout netting in reducing counterparty exposure.

	Counterparty A	Counterparty B	Counterparty C	Counterparty D	Market
Net assets against A	NA	0	0	0	0
Net assets against B	10	NA	0	0	10
Net assets against C	30	5	NA	10	45
Net assets against D	0	40	0	NA	40
Net assets against all counterparties	40	45	0	10	95

Central Counterparties

Our previous discussion of netting implicitly assumes that each agreement is a bilateral agreement between two counterparties. In a bilateral agreement, counterparties remain obligated to each other during the life of the agreement, and bilateral netting takes place across the agreements between the two counterparties. An alternative mechanism exists that permits multilateral netting. This mechanism is facilitated by an entity called a central counterparty clearinghouse (CCP). In a market that utilizes a CCP, counterparties enter into agreements with each other to transact in the future. Then, once the agreement is executed, through a process called novation, the counterparties switch from being counterparties with each other to being counterparties with the CCP. Hence, the original counterparties are no longer exposed to each other's counterparty credit risk but face counterparty exposure against the CCP.

The existence of CCPs and the novation mechanism works to reduce counterparty exposure in two ways. First, the CCP works to maintain high credit ratings, through objective and conservative margin requirements and careful monitoring of margin levels, among other means. Hence, the CCP is likely a safer counterparty than one's original counterparty. Second, the existence of CCPs allows for multilateral netting rather than bilateral netting. Since the CCP is one's counterparty for all agreements, netting can occur against the CCP instead of netting against each of one's counterparties on a bilateral basis. This allows for more extensive netting and therefore less exposure.

To demonstrate the usefulness of multilateral netting, let's return to the example explored in the previous section and previously illustrated in Figures 11.1 and 11.2 and Tables 11.3 and 11.4. As illustrated in Figure 11.3, counterparties A, B, C, and D no longer hold gross assets against each other. Instead, they all hold gross assets against the CCP. Figure 11.4 and Table 11.5 show the impact of netting when there is a CCP. Most noteworthy is that the total net assets across all counterparties across the entire market is 75, less than the 95 of exposure identified in Table 11.4.

	Counterparty A	Counterparty B	Counterparty C	Counterparty D	CCP
Net assets against A	NA	0	0	0	0
Net assets against B	0	NA	0	0	0
Net assets against C	0	0	NA	0	45
Net assets against D	0	0	0	NA	30
Net assets against the CCP	40	40	0	0	NA
Net assets against all counterparties	40	35	0	0	75

COUNTERPARTY CREDIT RISK AND SYSTEMIC RISK

The Credit Crisis of 2007–2009 has led to intense scrutiny of the willingness and ability of financial institutions to manage counterparty credit risk. Indeed, counterparty credit risk is perceived as a source of systemic risk. A financial institution that has built up a large asset position against a counterparty will be forced to write down the value of the assets should the counterparty experience financial distress, which can lead to the financial institution's insolvency. Hence, counterparty credit risk can lead to a cascade of write-downs and financial distress. To illustrate, consider a market in which there are three agreements: between counterparties A and B, counterparties B and C, and counterparties C and D. The financial distress of A requires counterparty B to write down the value of its assets against A. But this can lead to financial distress for counterparty B, which requires counterparty C to write down the value of its assets against B. But this can lead to financial distress for counterparty C, which requires counterparty D to write down the value of its assets against C. While this is a simplistic example, it does illustrate the key concern: The failure of one counterparty can lead to a cascade of failures and, ultimately, be a source of systemic risk. Several factors made the concerns regarding systemic risk during the Credit Crisis of 2007–2009 particularly acute.

First, while CCPs were available pre-Crisis for some varieties of OTC derivatives, most OTC derivatives agreements were privately negotiated bilateral agreements between counterparties that did not utilize CCPs; hence, counterparties were able to build up large asset positions against each other without the benefits of multilateral netting. This was unlike exchange-traded derivatives, which mandated the use of CCPs and thereby facilitated multilateral netting.

Second, as these were private bilateral agreements, there was limited understanding on the part of regulators of the nature of exposure that counterparties faced.

Third, counterparties to transactions were often financial institutions. Should a financial institution fail, its value drops precipitously—much more precipitously than, for example, the value of an auto manufacturer following a bankruptcy. Hence, there is little recovery value associated with financial institutions upon insolvency; and, therefore, the write-downs are significant.

Fourth, the products and strategies that were the source of counterparty exposure were often poorly understood, and there was often difficulty in accurately evaluating the counterparty exposure. Notably, during the period before the financial crisis, there was significant growth in exposure to credit default swaps and various structured credit vehicles such as collateralized debt obligations. Certain positions and strategies exposed counterparties to credit risk, market risk, liquidity risk, and counterparty credit risk in ways that were neither fully understood nor measured.

Fifth, while many products and strategies were a significant source of exposure, when initially executed they were off-balance-sheet exposures. For example, as noted earlier, for a derivative security in which both counterparties are obligated to transact in the future, the contract is structured at initiation such that the value of each of the counterparties' positions is neither an asset nor a liability. This off-balance-sheet nature meant that the traditional methods of reporting and evaluating exposure were not useful.

While the financial crisis has led to intense scrutiny of the willingness and ability of financial institutions to manage counterparty credit risk, it is less than clear that counterparty credit risk led to the crisis or is even a source of systemic risk. In the next chapter, we will explore methods of measuring counterparty exposure and look at data to evaluate the degree of exposure. We will also explore Title VII of the Dodd-Frank Act, which works to address the counterparty credit risk exposure associated with OTC derivatives.

KEY POINTS

• A derivative security is an agreement between two counterparties to transact in the future in which the counterparties' profit or loss is a function of the value of an underlying asset.
• Derivative securities may trade on a derivatives exchange or through an over-the-counter (OTC) derivatives market.
• A forward contract is an OTC derivatives agreement in which two counterparties agree to transact an underlying asset in the future for a price that is agreed upon at initiation. A futures contract is an exchange-traded version of a forward contract.
• An option contract is an agreement in which two counterparties agree to transact an underlying asset in the future for a price that is agreed upon at initiation, in which one of the counterparties has the right and not the obligation to transact in the future. Options trade both OTC and through exchanges.
• By a call option, the long counterparty has the right to purchase the underlying asset for a fixed price in the future from the short counterparty. By a put option, the long counterparty has the right to sell the underlying asset for a fixed price in the future to the short counterparty.
• A swap is an agreement between two counterparties to exchange cashflows over a number of periods of time in the future. By an interest rate swap, two counterparties agree to exchange a fixed rate of interest for a floating rate of interest over a number of periods of time. By a cross-currency swap, two counterparties agree to exchange cashflows in distinct currencies over a number of periods of time. By a credit default swap, one of the counterparties agrees to make periodic payments and the second counterparty agrees to make a large payment to the first counterparty should a specified reference asset issued by a specified reference entity experience a credit event. The notional principal translates the rates associated with swaps into cashflows.
• Typically, both counterparties to a swap are obligated to make payments of cashflows. However, in some swaps, such as caps, floors, and swaptions, one of the counterparties has a right while the other counterparty has an obligation, similar to an option. Swaps trade through OTC derivative markets.
• The counterparty to a given derivative security whose position is an asset faces counterparty exposure. Should the liability counterparty experience financial distress and be unable to satisfy its obligations, the asset counterparty will have to write down the value of its asset to reflect whatever recovery it expects to obtain from the financially distressed liability counterparty.
• By derivative security in which both counterparties are obligated to transact in the future, the contract is structured at initiation such that the value of each of the counterparties' positions is neither an asset nor a liability. Once the agreement is executed, the drivers of value will change and the position will become an asset for one of the counterparties and a liability to the other counterparty.
• By a derivative security in which one of the counterparties has the right to transact in the future and the other counterparty has an obligation, the derivative security is always an asset for the counterparty with the right and always a liability for the counterparty with an obligation.
• Counterparty credit risk exposure is managed through the use of collateral, netting, and central counterparties. Collateral refers to property that the counterparties to an agreement pledge to each other, which they agree to forfeit if they do not satisfy their obligations per the agreement. Netting refers to the offsetting of positions.
• Payment netting is the netting that occurs when payments are netted out and only a single payment is made. Closeout netting occurs when one of the counterparties to an agreement experiences a termination event, at which time the gross assets and gross liabilities across all of the agreements are netted out.
• In a market that utilizes a central counterparty clearinghouse (CCP), counterparties enter into agreements with each other to transact in the future. Once executed, through a process called “novation,” the counterparties switch from being counterparties with each other to being counterparties with the CCP.
• One benefit associated with a CCP is that a CCP is likely a safer counterparty than the original counterparties. Another benefit is that CCPs allow for multilateral netting, whereby netting occurs against the CCP instead of counterparties netting against each other on a bilateral basis.
• The Credit Crisis of 2007–2009 has led to intense scrutiny of the willingness and ability of financial institutions to manage counterparty credit risk and has led counterparty credit risk to be perceived as a source of systemic risk. Several factors driving this perception include the private bilateral nature of most OTC derivatives agreements pre-Crisis; limited understanding on the part of regulators of the nature of exposures; the low recovery values associated with insolvent financial institutions; poorly understood and difficult-to-evaluate products and strategies; and the off-balance-sheet nature of exposures.