Credit Risk

Credit Risk and Collateralization

Credit risk is the danger that a firm will not receive an amount of money it is owed because the party that owes the firm the money is unable to pay or otherwise defaults on its obligation. Credit risk exists whenever a firm has a relationship where a counterparty has an obligation to make payments or deliveries in the future.

There are five main ways to address the credit risk arising from a derivatives transaction, as follows:

• being financially strong enough and having enough capital set aside to accept the risk of nonpayment;
• making the risk as small as possible through the use of close-out netting (which can be achieved by appropriate netting arrangements – if default occurs, these documents act to consolidate multiple obligations between two parties into a single net obligation);
• having another person or entity reimburse losses, similar to the insurance, financial guarantee and credit derivatives markets; and
• obtaining the right of recourse to some asset of value that can be sold or the value of which can be applied in the event of default on the transaction: ideally, firms would like an asset of stable and predictable value, an asset that is not linked to the value of the transaction in any way and an asset that can be sold quickly and easily if the need arises.

This latter method of credit risk mitigation provides the context for collateralization as a means of managing the credit risk associated with derivatives transactions. Collateralization provides protection in the event of a default on a transaction, since the collateral receiver has recourse to the collateral asset and can thus make good some or all of the loss suffered.

It has become a risk-reduction method of choice for banks and non-bank financial institutions for many reasons; it caters for the disparity in credit-worthiness between parties, it reduces capital requirements which frees up capital for other investment purposes, and it improves transaction pricing by reducing the credit spread that is charged to a counterparty. It also eliminates the need to fund derivative receivables if the underlying derivative becomes an asset (i.e. has positive net present value) Credit risk charging relates to the cost of the credit risk that a dealer takes.

It may directly reflect the cost of the hedging of such credit risk, for example via the purchase of credit derivative contracts, charges may also reflect the funding cost of the derivative position. To the extent that collateralization reduces such credit and funding risk, then such charges may be reduced. In managing credit risk, consideration may be given to the cost of hedging credit risk relative to the cost of funding collateral.

This will vary from counterparty to counterparty, based on a range of factors, including the access to collateral that a counterparty has, its operational ability to provide collateral, and the existence of an appropriate credit derivative market. … Some counterparties (in particular corporates) may be practically unable to post collateral so credit risk is managed in a different way. It should be remembered that blanket recommendations for particular collateral provisions within credit support arrangements should be resisted because credit derivatives, or other means of reducing credit risk, may provide a cheaper and better solution, dependent on the circumstances of the case.

Collateralization can also be viewed as a risk transformation technique, in which the beneficial effect on counterparty credit risk is exchanged for a combination of:

• Operational risk (i.e. the risk that a failure to properly effect anticipated processes leads
  to a shortfall in protection), and;
• Residual credit risk (resulting from the below circunstances)

Residual credit risk resulting from:

• increases in exposure that occur between the last settled margin call prior to
  counterparty default and the point that a party’s final loss amount is crystallized;
• reductions in the value of securities collateral, again occurring between receipt of the
  collateral and crystallization of loss amount, and;
• over-collateralization, including but not limited to that arising from the pledging of
  Independent Amounts.

In addition, there are inherent costs to managing these risks; legal expenses associated with the
negotiation process and development and maintenance of necessary documentation, operational and technology costs associated with administering the process, and custody fees and financing costs associated with pledging, receiving and monitoring collateral.

According to the ISDA Margin Survey 2010 Preliminary Results, 78% of all derivatives trades are subject to collateral arrangements. However, this blended result needs to be treated with some caution as it reflects a wide range of asset-class-specific underlying results. For example, the collateralized percentage for credit derivatives is substantially higher at 97%, whereas for the FX, metals and commodities markets the levels are lower. These differences are in part reflective of the riskiness of the underlying trades. For example, some markets such as FX are spot or very short-dated and thus present lower risk that is not practical or economic to secure with collateral. Other markets, such as metals, energy and commodities use collateral selectively but may employ other forms of credit protection such as letters of credit instead.

It should also be noted that the blended rate is not weighted according to market size – the interest rate derivative market, for example, is several multiples of the commodity derivatives market in scale. (1)

Exposure by Collateralization

It is important to note that banks, asset managers, corporations and other entities are generally free to assume credit risk at their own discretion, with some limited exceptions. Banks, in particular, are in the business of taking credit risk, which is weighed carefully against the probability of default, the size of potential losses relative to capital, and consideration of any loss mitigation that may exist. Unless otherwise established by contract, official rules or statute there is no obligation on any party that any OTC derivative transaction must be collateralized.

If the parties do elect to collateralize, there is no requirement that particular commercial terms be established, for example, unsecured thresholds of particular size or excess collateral requirements – these are all commercial and credit risk management decisions subject to negotiation between the parties. This structural flexibility that allows parties to express a wide range of risk appetites, and to hedge a wide array of risks, is an essential hallmark of the OTC derivatives market, and one of the underpinning foundations of modern financial markets. (2)

Resources

Notes

1. Market Review of OTC Derivative Bilateral Collateralization Practices. International Swaps and Derivatives Association – March 1, 2010
2. Id.

See Also

• Collateralization
• Financial Risk
• Collateral Asset
• Collateral
• Risk Retention
• Risk Management
• Commercial Risk
• Back-To-Back Letter Of Credit
• Currency Risk
• Usance Credit
• Transfer Risk