Mitigating Counterparty Credit Risk in OTC Markets: The Basics

By John Kiff*

A central counterparty (CCP) reduces systemic counterparty credit risk by applying multilateral netting. This post discusses key tools of over-the-counter (OTC) counterparty credit risk mitigation, including netting and the collateralization of residual net exposures, and explains how a CCP reduces systemic counterparty risks. A follow-up post by one of my IMF colleagues (Jodi Scarlata) will delve deeper into the particulars of CCPs for credit default swaps.

An OTC contract is exposed to counterparty default risk prior to the contract’s expiration while it has a positive replacement value. In the absence of bilateral closeout netting, the maximum loss to a defaulted counterparty is equal to the sum of the individual contracts’ positive replacement values. The figure below shows two bilateral contracts. A owes B $5 on one contract, and is owed $10 from B on the second one. A faces a $10 loss if B defaults. This all assumes that the counterparties have signed a master agreement with the appropriate closeout provisions that covers both transactions. If they had not, B could “cherry pick” A by defaulting on its obligation to pay the $10, but insisting that A still pay the $5. In this case, A loses $15.

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Closeout netting aggregates all exposures between the counterparties, under a default, and contracts with negative values can be used to offset those with positive values. Hence, the total exposure associated with all contracts covered by the particular master agreement is reduced to the maximum of the sum of the replacement values of all the contracts and zero. A loses $5 if B defaults. The exposure can be further reduced by requiring counterparties to post collateral (cash and highly-rated liquid securities) against outstanding exposures, usually based on the previous day’s valuations.

For more detail on OTC derivative collateral and netting practice see Bliss and Kaufmans’ “derivatives and systemic risk” paper. For surveys of OTC derivative counterparty credit risk exposure management practices, including collateral policies, see “new developments in clearing and settlement arrangements for OTC derivatives” by the Bank for International Settlements Committee on Payment and Settlement Systems, and “counterparty credit exposure among major derivatives dealers” by the International Swaps and Derivatives Association. Best practice guides can be found in the 2005 and 2008 reports by the Counterparty Risk Management Policy Group.

The second figure shows contracts across four counterparties, all of whom have bilateral closeout netting master agreements with each other applies. The numbers on the arrows indicate the net bilateral flow (A, B, C and D, clockwise from the top left corner), and the subscripted “E” indicates the maximum counterparty exposure for the counterparty. Thus, ED = $10, because both A and B owe D $5. Each counterparty faces a maximum counterparty default-related loss of either $5 or $10. C loses $10 if both A and D fail, and D is vulnerable to the simultaneous default of A and B. Hence, A and B should each provision against $5 of potential counterparty credit losses, and C and D should each provision for $10, for a total of $30, even though the maximum potential loss among all four is only $10.

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Multilateral netting, typically operationalized via “tear-up” or “compression” operations that eliminate redundant contracts, reduces both individual and system counterparty credit risk. In this case, it could eliminate four contracts, and eliminate all A’s and B’s counterparty credit risk exposure, and leave C and D with $5 of maximum potential individual losses. The third figure shows the two possible post-netting configurations. The leftmost configuration eliminates the circular BACB flow, and replaces the BDC flow with a more direct BC flow. The rightmost configuration just needs to eliminate the circular BADC flow. Using such tearup operations, TriOptima’s TriReduce service eliminated about $30 trillion notional of credit default swap contracts in 2008.

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A sound CCP takes the multilateral netting principle a step further, and reduces the likelihood of knock-on failures by requiring the participants to post margin, and by loss sharing among other clearinghouse members. Other typical arrangements include capital funds comprised of clearing member contributions and accumulated profi ts and transaction fee rebates. All of this will be covered in more detail by Jodi, but see also Bliss and Steigerwalds’  “derivatives clearing and settlement: A comparison of central counterparties and alternative structures”).

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* John Kiff is a Senior Financial Sector Expert at the IMF. These are his personal views, and should not be attributed to the IMF, its Executive Board, or its management.

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