P2.T6.

Credit Risk Measurement & Management

Jon Gregory, The xVA Challenge: Counterparty Credit Risk,

Funding, Collateral, and Capital

Counterparty Risk Intermediation

Bionic Turtle FRM Video Tutorials

By David Harper, CFA FRM
Counterparty Risk Intermediation
• Identify counterparty risk intermediaries including central counterparties
(CCPs), derivative product companies (DPCs), special purpose vehicles
(SPVs), and monoline insurance companies (monolines) and describe
their roles.
• Describe the risk management process of a CCP and explain the loss
waterfall structure of a CCP.
• Compare bilateral and centrally cleared over-the-counter (OTC) derivative
markets.
• Discuss the impact of central clearing on credit value adjustment (CVA),
funding value adjustment (FVA), capital value adjustment (KVA), and
margin value adjustment (MVA).

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Introduction
The different forms of counterparty risk intermediation can be seen as a progression towards
central clearing (creating a number of other risks along the way):

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Introduction

Special purpose vehicles

An SPV is a wrapper aiming to create a bankruptcy-remote entity and give a

counterparty preferential treatment as a creditor in the event of a default. It
therefore introduces legal risk if this beneficial treatment is not upheld in the event
of a default.

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Introduction

Guarantees

A guarantee is where a third party guarantees the performance of a derivative

counterparty. This introduces the concept of “double default:” both the original
derivative counterparty and the guarantor must fail to lead to a loss. Clearly, to be
effective, the party providing the guarantee should be of higher credit
standing than the original counterparty, and there must be no clear relationship
between them.

• One common and simple sort of guarantee is intragroup,

where a trading subsidiary is guaranteed by its parent company.
• Another example is a letter of credit from a bank, which will
typically reference a specified amount.

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Derivative product companies. A derivative product company (DPC) essentially
takes the above idea further by having additional capital and operational rules,
introducing operational and market risks. DPCs are a special form of intermediation
where an originating bank sets up a bankruptcy-remote SPV and injects capital to
gain a preferential and strong credit rating (typically triple-A).

• Monolines and credit DPCs can be seen as a specific application of this idea to
credit derivative products where wrong-way risk is particularly problematic due
to the obvious relationship between the counterparty and reference entities in
the contracts.

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 Central counterparty (CCP). A CCP extends the DPC concept by requiring
collateral posting and default funds, and uses methods such as loss mutualization
to guarantee performance. This introduces liquidity risk since the CCP aims to
replace contracts in the event of a default. The size of CCPs also creates systemic
risk.

• A CCP clearing credit default swaps (CDSs) can be seen

as a progression from a CDPC and has arguably a more
difficult role due to the underlying wrong-way risks.

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Identify counterparty risk intermediaries and describe their
roles: special purpose vehicles (SPVs).
An SPV aims to create a bankruptcy-remote entity and give a counterparty
preferential treatment as a creditor in the event of a default. It introduces
legal risk if this beneficial treatment is not upheld in the event of a default.

• A company will transfer assets to the SPV for management or use the SPV to
finance a large project without putting the entire firm or a counterparty at risk.

• Jurisdictions may require that an SPV is not owned by the entity on whose
behalf it is being set up.

• SPVs aim to change bankruptcy rules so if a derivative counterparty is insolvent,

a client can still receive their full investment prior to other claims being paid out.

• SPVs are used in structured notes where they use this mechanism to guarantee
the counterparty risk on the principal of the note to a high level, better than
that of the issuer.

• The creditworthiness of the SPV is assessed by rating agencies who

look at the mechanics and legal specifics before granting a rating.

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Identify counterparty risk intermediaries and describe their
roles: derivative product companies (DPCs).
DPCs are a of intermediation where an originating bank sets up a
bankruptcy-remote SPV and injects capital to gain a preferential and
strong credit rating (typically triple-A).

• The DPC structure provides external counterparties with a degree

of protection against counterparty risk by protecting against the
failure of the DPC parent.

• DPCs maintain a triple-A rating by a combination of capital,

collateral and activity restrictions. Each DPC has its own
quantitative risk assessment model to quantify their current credit
risk, benchmarked against that required for a triple-A rating.

• DPCs also give security by defining an orderly workout

process. A DPC defines what events would trigger its own
failure and how the resulting workout process would work.

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Identify counterparty risk intermediaries and describe their
roles: monoline insurance companies (monolines).
Monoline insurance companies are financial guarantee companies with
triple-A ratings that they utilize to provide financial guarantees.

• The monolines provide financial guarantees for US

municipal bond issues, providing unrated borrowers with
triple-A credit ratings and enabling them to sell their
bonds to investors at attractive levels.

• In order to justify their ratings, monolines have capital

requirements driven by the possible losses on the structures.
These capital requirements are related to the portfolio of
assets that they wrap. Importantly, the monolines would
typically not post collateral against their transactions.

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Identify counterparty risk intermediaries and describe their
roles: derivative product companies (DPCs) (continued)
The rating of a DPC typically depends on:

• Minimizing market risk: DPCs can attempt to be close to market-

neutral via trading offsetting contracts. Ideally, they would be on
both sides of every trade, as these “mirror trades” lead to an overall
matched book. Usually the mirror trade exists with the DPC parent.

• Support from a parent: The DPC is supported by being

bankruptcy-remote from the parent to achieve a better rating. If
the parent were to default, then the DPC will either pass to
another well-capitalized institution or be terminated in an orderly
fashion with transactions settled at mid-market.

• Credit risk management and operational guidelines (limits, collateral terms,

etc.): Restrictions are imposed on (external) counterparty credit quality and
activities. The management of counterparty risk is achieved by having daily MTM
and collateral posting.

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Identify counterparty risk intermediaries and describe their
roles: central counterparties (CCPs).
A CCP requires collateral posting and default funds, and uses methods such as
loss mutualization to guarantee performance. A CCP guarantees counterparty
risk, and provides a centralized entity where aspects such as collateral management
and default management are handled.
• The main function of an OTC CCP is to interpose itself
between counterparties to assume their rights and obligations
by acting as buyer to every seller and vice versa.

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Identify counterparty risk intermediaries and describe their
roles: central counterparties (CCPs).
A CCP requires collateral posting and default funds, and uses methods such as
loss mutualization to guarantee performance. A CCP guarantees counterparty
risk, and provides a centralized entity where aspects such as collateral management
and default management are handled.
• The main function of an OTC CCP is to interpose itself between
counterparties to assume their rights and obligations by acting as
buyer to every seller and vice versa.

• CCPs reallocate default losses via a variety of methods, including

netting, collateralization and loss mutualization. The intention is that
the overall process will reduce counterparty and systemic risks.

• CCPs facilitate close-outs by auctioning the defaulter’s contractual

obligations with multilateral netting, reducing the total positions that need
to be replaced which minimizes price impacts and market volatility.

Some banks and most end-users of OTC derivatives will access CCPs
through a clearing member and will not become members themselves.

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 Identify counterparty risk intermediaries and describe their
roles: central counterparties (CCPs).
The general role of an OTC CCP is that it:
• sets certain standards and rules for its clearing members;
• takes responsibility for closing out all the positions of a defaulting clearing member;
• to support the above, it maintains financial resources to cover losses in the event of
a clearing member default:
 variation margin to closely track market movements;
 initial margin to cover worst case liquidation or close-out costs above the
variation margin; and
 a default fund to mutualize losses in the event of a severe default.

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 Identify counterparty risk intermediaries and describe their
roles: central counterparties (CCPs).
The CCP also has a documented plan for the very extreme situation when all their
financial resources (initial margin and the default fund) are depleted. For example:
• additional calls to the default fund;
• variation margin haircutting; and
• selective tear-up of positions.

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Describe the risk management process of a CCP and explain
the loss waterfall structure of a CCP.
Figure 9.5 – Illustration of a typical loss waterfall defining the way in which
the default of one or more CCP members is absorbed.

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Compare bilateral and centrally cleared over-the-counter
(OTC) derivative markets.
Bilateral Centrally cleared
Counterparty Original CCP
Products All Must be standard,
vanilla, liquid etc.
Participants All Clearing members are
usually large banks
Other collateral
posting entities can
clear through clearing
members
Collateral Bilateral, bespoke Full collateralization,
arrangements dependent including initial margin
on credit quality and open enforced by CCP.
to disputes. New
regulatory rules being
introduced from
September 2016

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Compare bilateral and centrally cleared over-the-counter
(OTC) derivative markets.
Bilateral Centrally cleared
Capital charges Default risk and CVA Trade level and
capital default fund related
(see below)
Loss buffers Regulatory capital and Initial margins, default
collateral (where funds and CCP own
provided) capital
Close-out Bilateral Coordinated default
management process
(e.g. auctions)
Costs Counterparty risk, funding Funding (initial
and capital costs margin) and (lower)
capital costs

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(… Advantages of a CCP)

Advantages of a CCP:
• Transparency. A CCP may face a clearing member for a large
proportion of their transactions in a given market and can
therefore see concentration that would not be transparent in
bilateral markets.
• Offsetting
• Loss mutualization
• Legal and operational efficiency: collateral, netting and
settlement functions.
• Liquidity. A CCP may improve market liquidity through the ability
of market participants to trade easily and benefit from multilateral
netting. Barriers to market entry may be reduced. Daily collateral
calls may lead to a more transparent valuation of products.
• Default management. A well-managed central auction may
result in smaller price disruptions than the uncoordinated
replacement of positions during a crisis period associated with
default of a clearing member.

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(… Disadvantages of a CCP)

Disadvantages of a CCP:
• Moral hazard. Parties have little incentive to monitor each
other’s credit quality and act appropriately because a third party
is taking most of the risk.
• Adverse selection. CCPs are also vulnerable to adverse
selection, which occurs if members trading OTC derivatives know
more about the risks than the CCP themselves.
• Bifurcations. The requirement to clear standard products may
create unfortunate bifurcations between cleared and non-cleared
trades. This can result in highly volatile cashflows for customers,
and mismatches for seemingly hedged positions.
• Procyclicality. Procyclicality refers to a positive dependence
with the state of the economy. CCPs may create procyclicality
effects by, for example, increasing collateral requirements (or
haircuts) in volatile markets or crisis periods.

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Discuss the impact of central clearing on credit value adjustment
(CVA), funding value adjustment (FVA), capital value adjustment
(KVA), and margin value adjustment (MVA).
Central clearing of OTC derivatives reduce counterparty risk
through the risk management practices of the CCP, in
particular with respect to the collateral they require.

• This would imply that CVA and associated capital charges

(KVA) would no longer be a problem when clearing though
a CCP.

• Given an increasing amount of OTC derivatives being

centrally cleared, this would imply that CVA would become
less of an issue in the light of the clearing mandate.

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Discuss the impact of central clearing on credit value adjustment
(CVA), funding value adjustment (FVA), capital value adjustment
(KVA), and margin value adjustment (MVA) (continued)
There are two problems with the views on the previous slide
• Firstly, counterparty risk, funding and capital issues (CVA, FVA,
KVA) arise from uncollateralized OTC derivatives with non-financial
end-users.
Since such end-users will be exempt from the clearing mandate,
they will not move to central clearing except on a voluntary basis.
Since most such end-users find it difficult to post collateral, such
voluntary clearing is unlikely. Hence, the uncollateralised bilateral
transactions that are most important from a valuation adjustment
perspective will persist as such.

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Discuss the impact of central clearing on credit value adjustment
(CVA), funding value adjustment (FVA), capital value adjustment
(KVA), and margin value adjustment (MVA) (continued)
There are two problems with the views on the previous slide
• Firstly, counterparty risk, funding and capital issues (CVA, FVA,
KVA) arise from uncollateralised OTC derivatives with non-financial
end-users.
Since such end-users will be exempt from the clearing mandate,
they will not move to central clearing except on a voluntary basis.
Since most such end-users find it difficult to post collateral, such
voluntary clearing is unlikely. Hence, the uncollateralised bilateral
transactions that are most important from a valuation adjustment
perspective will persist as such.

• Secondly, central clearing and other changes may reduce

components such as CVA, but will also increase other components.
Hence, it will become even more important to consider the valuation
adjustments holistically to understand the balance of various effects.

In general, central counterparties transform valuation

adjustments: components such as CVA, FVA and KVA are
reduced whilst MVA is increased and KVA changes form.

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The End

P2.T6. Credit Risk Measurement & Management

Jon Gregory, The xVA Challenge: Counterparty Credit Risk, Funding,

Collateral, and Capital

Counterparty Risk Intermediation