Collateral agreements (Section 6.2) specify the contractual posting of cash or securities against MTM losses. Taking collateral to minimise counterparty risk creates operational risk due to the necessary logistics involved and market risk, since exposure exists in the time taken to receive the relevant collateral amount. Collateralisation of counterparty risk also leads to liquidity risk, since the posting of collateral needs to be funded and collateral itself may have price and FX volatility. Aspects such as rehypothecation (reuse) and segregation of collateral are important considerations here (Section 6.4.2 and 6.4.3). Like netting, collateral also increases the losses of other creditors in a default scenario (Section 6.6.1).
• Other contractual clauses. Other features, such as resets or additional termination events (Section 5.5.2), aim to periodically reset MTM values or terminate transactions early. Like collateral, these can create operational and liquidity risks.
• Hedging. Hedging counterparty risk with instruments such as credit default swaps (CDSs) aims to protect against potential default events and adverse credit spread movements. Hedging creates operational risk and additional market risk through the mark-to-market (MTM) volatility of the hedging instruments. Taking certain types of collateral can create wrong-way risk (Chapter 17). Hedging may lead to systemic risk through feedback effects (see the statement from the Bank of England in Section 2.4).
• Central counterparties. Central counterparties (CCPs) guarantee the performance of transactions cleared through them and aim to be financially safe themselves through the collateral and other financial resources that they require from their members. CCPs act as intermediaries to centralise counterparty risk between market participants. Whilst offering advantages such as risk reduction and operational efficiencies, they require the centralisation of counterparty risk, significant collateralisation and mutualisation of losses. They can therefore potentially create operational and liquidity risks, and also systemic risk, since the failure of a central counterparty could amount to a significant systemic disturbance. This is discussed in more detail in Chapter 9.
Mitigation of counterparty risk is a double-edged sword. On the one hand, it may reduce existing counterparty risks and contribute to improving financial market stability. On the other hand, it may lead to a reduction in constraints such as capital requirements and credit limits, and therefore lead to a growth in volumes. Indeed, without risk mitigants such as netting and collateral, the OTC derivatives market would never have developed to the size it is today. Furthermore, risk mitigation should really be thought of as risk transfer, since new risks and underlying costs are generated.
Another way to see some of the risk conversion described above is in xVA terms. CVA may be reduced but another xVA component created. Indeed, later chapters of this book will discuss this conversion between xVA terms in detail. For now, some obvious examples are:
• Collateral. Creates FVA (due to the need to fund collateral posting) and ColVA (due to the optionality inherent in the collateral agreement).
• Termination clauses. Aspects such as early termination events (possibly linked to downgrade triggers) create MVA that has been exasperated due to regulatory requirements regarding liquidity buffers (Section 16.2.1).
• Central clearing and bilateral collateral rules. The requirement to post additional collateral in the form of initial margin creates MVA.
• Hedging. Hedging CVA for accounting purposes may create additional capital requirements and therefore increase KVA. On the other hand, reducing KVA may lead to greater CVA volatility (Section 18.3.8).
The above explains why it is critical to manage xVA centrally and make consistent decisions regarding pricing, valuation and risk mitigation so as to optimise aspects such as capital utilisation and achieve the maximum overall economic benefit.
The split of OTC derivatives by product type is shown in Figure 4.2. Interest rate products contribute the majority of the outstanding notional but this gives a somewhat misleading view of the importance of other asset classes, especially foreign exchange and credit default swaps. Whilst most foreign exchange products are short-dated, the long-dated nature and exchange of notional in cross-currency swaps means they have considerable counterparty risk. Credit default swaps not only have a large volatility component but also constitute significant “wrong-way risk” (discussed in detail in Chapter 17)
Figure 4.2 Split of OTC gross outstanding notional by product type as of June 2014.
The above can be seen when looking at the averaged response from banks on their CVA breakdown by asset class in Figure 4.3. Although interest rate products make up a significant proportion of the counterparty risk in the market (and indeed are most commonly used in practical examples), one must not underestimate the important (and sometimes more subtle) contributions from other products. It is also important to note that, while large global banks have exposure to all asset classes, smaller banks may have a more limited exposure (for example, mainly interest rate and FX products). End-users may also have limited exposure: for example, a corporate may use only interest rate and cross-currency swaps.
Figure 4.3 Split of CVA by asset class (average over all respondents).
Table 4.1 Comparison of the total notional outstanding and the market value of derivatives ($ trillions) for different asset classes as of December 2014.
* This is calculated as the sum of the absolute value of gross positive and gross negative market values, corrected for double counting.
Source: BIS.
A key aspect of derivatives products is that their exposure is substantially smaller than that of an equivalent loan or bond. Consider an interest rate swap as an example; this contract involves the exchange of floating against fixed coupons, and has no principal risk because only cashflows are exchanged. Furthermore, even the coupons are not fully at risk because, at coupon dates, only the difference in fixed and floating coupons or net payment will be exchanged. Comparing the actual total market of derivatives against the total notional amount outstanding therefore shows a significant reduction, as illustrated in Table 4.1. For example, the total market value of interest rate contracts is only 3.1 % of the total notional outstanding. It is the market value that is more relevant, since this is representative of the loss that is suffered in a default scenario and is the amount that has to be funded or collateralised.
Broadly speaking, there are two situations in which counterparty risk and related aspects such as funding, collateral and capital arise. The most obvious (Figure 4.4) would apply to an end-user using OTC derivatives for hedging purposes. Their overall portfolio will be typically directional (but not completely so, as mentioned below), since the general aim will be to offset economic exposures elsewhere. The result of this will be that MTM volatility will be significant and any associated collateral flows may vary substantially. Indeed, the fact that substantial collateral may be required over a short time horizon is one reason why many end-users do not enter into collateral agreements. Another implication of directional portfolios is that there may be less netting benefit available. In practice, an end-user will trade with a reasonable number of bank counterparties depending on the volume of their business and risk appetite.
