credit risk can generally be thought of as lending risk. One party owes an amount to another party and may fail to pay some or all of this due to insolvency. This can apply to loans, bonds, mortgages, credit cards and so on. Lending risk is characterised by two key aspects:
• The notional amount at risk at any time during the lending period is usually known with a degree of certainty. Market variables such as interest rates will typically create only moderate uncertainty over the amount owed. For example, in buying a bond, the notional amount at risk for the life of the bond is close to par. A repayment mortgage will amortise over time (the notional drops due to the repayments) but one can predict with good accuracy the outstanding balance at some future date. A loan or credit card may have a certain maximum usage facility, which may reasonably be assumed fully drawn16 for the purpose of credit risk.
• Only one party takes lending risk. A bondholder takes considerable credit risk, but an issuer of a bond does not face a loss if the buyer of the bond defaults.17
With counterparty risk, as with all credit risk, the cause of a loss is the obligor being unable or unwilling to meet contractual obligations. However, two aspects differentiate contracts with counterparty risk from traditional credit risk:
• The value of the contract in the future is uncertain – in most cases significantly so. The MTM value of a derivative at a potential default date will be the net value of all future cashflows required under that contract. This future value can be positive or negative, and is typically highly uncertain (as seen from today).
• Since the value of the contract can be positive or negative, counterparty risk is typically bilateral. In other words, each counterparty in a derivatives transaction has risk to the other.
A derivatives portfolio contains a number of settlements equal to multiples of the total number of transactions; for example, a swap contract will have a number of settlement dates as cashflows are exchanged periodically. Counterparty risk is mainly associated with pre-settlement risk, which is the risk of default of the counterparty prior to expiration (settlement) of the contract. However, we should also consider settlement risk, which is the risk of counterparty default during the settlement process.
• Pre-settlement risk. This is the risk that a counterparty will default prior to the final settlement of the transaction (at expiration). This is what “counterparty risk” usually refers to.
• Settlement risk. This arises at settlement times due to timing differences between when each party performs on its obligations under the contract.
The difference between pre-settlement and settlement risk is illustrated in Figure 4.1.
Figure 4.1 Illustration of pre-settlement and settlement risk. Note that the settlement period is normally short (e.g., hours) but can be much longer in some cases.
Example
Suppose an institution enters into a forward FX contract to exchange €1m for $1.1m at a specified date in the future. The settlement risk exposes the institution to a substantial loss of $1.1m, which could arise if €1m was paid but the $1.1m was not received. However, this only occurs for a single day on expiry of the FX forward. This type of cross-currency settlement risk is sometimes called Herstatt risk (see box below). Pre-settlement risk (counterparty risk) exposes the institution to just the difference in market value between the dollar and Euro payments. If the foreign exchange rate moved from 1.1 to 1.15, this would translate into a loss of $50,000, but this could occur at any time during the life of the contract.
Unlike counterparty risk, settlement risk is characterised by a very large exposure – potentially, 100 % of the notional of the transaction. Whilst settlement risk gives rise to much larger exposures, default prior to expiration of the contract is substantially more likely than default at the settlement date. However, settlement risk can be more complex when there is a substantial delivery period (for example, as in a commodity contract where one may be required to settle in cash against receiving a physical commodity over a specified time period).
Whilst all derivatives technically have both settlement and pre-settlement risk, the balance between the two will be different depending on the contract. Spot contracts have mainly settlement risk whilst long-dated swaps have mainly pre-settlement (counterparty) risk. Furthermore, various types of netting (see Chapter 5) provide mitigation against settlement and pre-settlement risks.
Case study: Bankhaus Herstatt
A well-known example of settlement risk is the failure of a small German bank, Bankhaus Herstatt. On 26th June 1974, the firm defaulted but only after the close of the German interbank payments system (3:30pm local time). Some of Herstatt Bank’s counterparties had paid Deutschemarks to the bank during the day, believing they would receive US dollars later the same day in New York. However, it was only 10:30am in New York when Herstatt’s banking business was terminated, and consequently all outgoing US dollar payments from Herstatt’s account were suspended, leaving counterparties fully exposed.
Settlement risk is a major consideration in FX markets, where the settlement of a contract involves a payment of one currency against receiving the other. Most FX now goes through CLS18 and most securities settle DVP,19 but there are exceptions, such as cross-currency swaps, and settlement risk should be recognised in such cases.
Settlement risk typically occurs for only a small amount of time (often just days, or even hours). To measure the period of risk to a high degree of accuracy would mean taking into account the contractual payment dates, the time zones involved and the time it takes for the bank to perform its reconciliations across accounts in different currencies. Any failed trades should also continue to count against settlement exposure until the trade actually settles. Institutions typically set separate settlement risk limits and measure exposure against this limit rather than including settlement risk in the assessment of counterparty risk. It may be possible to mitigate settlement risk, for example by insisting on receiving cash before transferring securities.
Recent developments in collateral posting have the potential to increase currency settlement risk. The standard CSA (Section 6.4.6), the regulatory collateral requirements (Section 6.7) and central clearing mandate (Section 9.3.1) incentivise or require cash collateral posting in the currency of a transaction. These potentially create more settlement risk, and associated liquidity problems, as parties have to post and receive large cash payment in silos across multi-currency portfolios.
There are a number of ways of mitigating counterparty risk. Some are relatively simple contractual risk mitigants, whilst other methods are more complex and costly to implement. Obviously, no risk mitigant is perfect, and there will always be some residual counterparty risk, however small. Furthermore, quantifying this residual risk may be more complex and subjective. In addition to the residual counterparty risk, it is important to keep in mind that risk mitigants do not remove counterparty risk per se, but instead convert it into other forms of financial risk, some obvious examples being:
• Netting. Bilateral netting agreements (Section 5.2.4) allow cashflows to be offset and, in the event of default, for MTM values to be combined into a single net amount. However, this also creates legal riskw in cases where a netting agreement cannot be legally enforced in a particular jurisdiction and also exposes other creditors to more significant losses.
•
On the basis that an individual unable to pay is likely to be close to any limit.
This is not precisely true in the case of bilateral counterparty risk (DVA), discussed in Chapter 14, although conventions regarding close-out amounts can correct for this.
Delivery versus payment, where payment is made at the moment of delivery, aiming to minimise settlement risk in securities transactions.
