Counterparty Risk Intermediation

In this chapter, the roles played by Derivative Product Companies (DPCs) and Monoline Insurers is covered by understanding counterparty risk mitigation through entities playing the role of inter-mediators and guarantees or insurance offered based on default events. OTC derivative counterparty risk is mitigated by central counterparties (CCPs) and in this chapter, we study how it happens. To ensure counterparty risk is mitigated, various techniques have been created by the OTC derivatives markets. The following are forms of counterparty risk inter-mediation that create various other risks by being considered as a progression towards central clearing:

  1. Special purpose vehicles: To create a bankruptcy-remote entity giving a counterparty preferential treatment as a creditor in the event of a default, an SPV will introduce legal risk in the event that this treatment fails to be upheld due to a default.
  2. Guarantees: In this case, the performance of a derivative counterparty is guaranteed by a third party.
  3. Derivative product companies: To gain a preferential and strong credit rating, an institution will set up a bankruptcy-remote SPV injecting capital, thereby making DPCs special intermediation forms.
  4. Central Counterparty (CCP): This is basically an extension of the concept of DPC, in that methods like metallization to guarantee performance is used to require collateral posting and default funds.

SPVS, DPCS, CDPCS, and Monolines

Default Remoteness and “Too Big to Fail”

Counterparty risks are essentially negligible as the default probability is given by the concept of a default-remote entity. The popular “too big to fail” notion is associated with this default-remote concept. Due to its correlation with other risks, the reluctance may be commonplace in assessing counterparty risk. The formal term used to refer to these counterparties is Systemically Important Financial Institutions (SIFIs). A hazardous issue has been witnessed by banks trading with SIFIs based on the belief that implicit governments and central bank support have been offered to them. Based on contemporary ratings, default remoteness has been a weakness to financial markets whereby due to flaw ratings, triple-A ratings have been offered to some “too big to fail” counterparties.

Special Purpose Vehicles (SPVs)

This happens to be a typically created legal entity purposely for the isolation from contemporary risk by a party and is also called Special Purpose Entity (SPE). However, ownership of SPVs by the entity on whose behalf it is being set up may be limited by jurisdictions. Counterparty risks are transferred by SPVs to legal risks whereby, depending on the jurisdiction, assets of the SPVs are consolidated by a court with those of the originator. However, as illustrated by the SPV concept, it is also risky to mitigate counterparty risk with the legal risks creation mechanisms.

Derivative Product Companies (DPCs)

As opposed to SPVs, DPCs are capitalized separately to obtain triple-A credit ratings and are set up by one or more financial institutions. By protecting against the failure of the of the DPC parent, external counterparties are provided by its structures with a degree of protection against counterparty risk. Through an amalgam of capital, collateral, and activity restrictions, a DPC can maintain its triple-A credit rating but is dependent on:

  1. Minimizing market risks through offsetting contracts, as DPCs can attempt to be close to market-neutral;
  2. The support from a parent to achieve better rating by being bankruptcy-remote; and
  3. Through credit risk management and operational guidelines, counterparty credit quality gets restrictions imposed on them.

An orderly workout definition by DPCs also gives further security all the while being a very good credit quality. However, the danger posed by relying on credit ratings as a credit quality measure poses a danger. Also, DPCs triple-A ratings possesses little credibility just like SPVs, since the faced counterparty was DPC parent with a worse credit rating.

Monolines and CDPs

Using the triple-A ratings, monoline insurance companies can provide financial guarantees. This mainly applies to US municipal bond issues that enable borrowers having triple-A credit ratings to sell these bonds to investors at attractive levels. The monolines also sell CDS protections as a way of diversifying spread risks and often have better returns. There exists a similarity between monolines and DPC structures in that in both instances, the capital requirement is dynamically related to the portfolio of assets they insure. Out of monolines and DPCs is born a new concept of Credit Derivative Product Companies (CDPCs) through the extension of the DPC model to credit derivative products. It is, however, special in that it is created to invest in credit derivative products on a leverage basis. A difference is notable between DPC and CDPC in that the former is a bankruptcy-remote subsidiary of an institution while the latter is created with an aim of making profit from selling credit derivative protections. CDPCs also have significant market risks due to the lack of offsetting abilities, unlike DPCs. The similarity between monolines and CDPC is that both act as high credit quality counterparts, but only as sellers of credit protection. Monolines and CDPCs were, however, deemed stable in the market until the global financial crisis that hit in 2007.

The 2007-2009 global financial crisis raised questions on the A-rating status granted to monolines as it emerged that they had insufficient capital to justify these ratings. They experienced MTM losses on the insurance they had sold. It also emerged that monolines had controversial clauses which would see any rating below A-ratings force them to post collateral which in they could not meet. Although CDPCs, just like monolines, are highly leveraged and could not post collateral, they performed better during the financial crisis mainly because they were not operational prior to the crisis and started operating in July 2007; hence, they missed the first wave of the crisis.

It is argued that monolines and CDPCs’ business model was fatally flawed in that as much as they offer systemic shock absorbers to counterparty risk, this kind of risk is taken care of through diversification by the said companies they insure. The failure of monolines and AIG, a deemed “too big to fail” insurance company, are important as they give a lesson to prospects like CCPs not to venture into similar roles like counterparty risk mitigation and systemic risk concentration as this would guarantee failure.

Central Counterparties

An important lesson from the analysis of monolines, CDPCs, DPCs, and SPVs is that overreliance on default-remote entities as a major counterparty is a poor way to mitigate counterparty risk. As much as it may seem that CCPs are receiving much support from regulators, they have their own complexities and risks.

The Clearing Mandate

During the global financial crisis of 2007-2009 came the collapse of monoline insurers, Lehman Brothers, and Icelandic Bank. Thereafter, counterparty risk in OTC derivative, especially in credit derivatives, was identified as the major risk to the financial system as a whole. It also raised operational and legal issues related to collateral management. However, the CCP concept seems to offer a solution to these problems by guaranteeing counterparty risk and providing a platform where collateral and default management issues are handled.

The bilateral OTC derivative market has the biggest challenge of close-out process in the event of default due to the legal processes involved. However, CCPs seem to offer a solution by enforcing close-out rules and ensuring continuity thereby reducing systemic rules. This was clearly evident in the aftermath of the Lehman Brothers bankruptcy. CCPs thus seem to be more coordinated than bilateral markets.

OTC Clearing

Clearing is the process that occurs after execution of a trade in which a CCP may come in between counterparties to guarantee performance.

OTC CCPs come in directly or indirectly between counterparties and assumes their obligations and rights by acting as a buyer to every seller and vice versa. CCPs relocates default losses by the use of methods like netting, collateralization, and loss mutualization with an aim to reduce systemic and counterparty risks. One advantage of CCPs is that they allow the netting of all trades executed through them. A second advantage is that CCPs also manage collateral requirement from their members to reduce the risk of movement in the value of the underlying portfolios. CCPs introduce a new perspective which isn’t seen in bilateral market, i.e., loss mutualization, where one counterparty’s losses are spread across all clearing members as opposed to being spread on a small number of counterparties which would lead to adverse potential consequences. CCPs also facilitate orderly close-outs by auctioning the defaulter’s contractual obligations. It also enables the orderly transfer of clients’ positions from financially distressed members to other members.

Roles of OTC CCPs

The main rules of CCPs are as follow:

  1. Setting up rules and standards for its clearing members;
  2. Responsible for closing out all the positions of a defaulting clearing member;
  3. Maintaining financial resources to cover losses in the event of clearing member default;
  4. Applying variation margins to closely track market movements.

Some banks and most end users of OTC derivatives access CCPs as a clearing member and will not become members themselves because of membership, operational, and liquidity requirements related to being a clearing member. CCPs make the failure of a counterparty less dramatic regardless of its size by acting as shock absorbers. Once a default occurs in one of its counterparties, a CCP terminates all financial relationships with other counterparties to ensure losses are not further experienced. The position of the defaulter is then auctioned to other counterparties to allow for continuity among the surviving members.

The CCP Landscape

A CCP brings into perspective a set of rules and operational arrangements that are designed to allocate, manage, and reduce counterparty risks in bilateral markets. It thus changes the topology of financial markets by posing between buyers and sellers.

However, the CCP landscape is complex and ignores the following aspects:

  • Client clearing: Parties that cannot be members of a CCP have to clear through a clearing member. This makes collateral transfer and default very complex and hard to deal with.
  • Bilateral trades: Some OTC derivatives are not suitable for clearing and a reasonable portion of derivatives contracts will always remain as bilateral transactions.
  • Multiple CCPs: There are clearly a number of different CCPs globally that may be implicitly interconnected through sharing members.

CCP Risk Management

Being at the center of the financial markets, it would be dangerous to operate without risk mitigation strategies. It could be catastrophic to imagine a CCP collapse. Therefore, the most obvious strategy is by use of collateral that CCPs require to cover the market risks of the trades they clear.

CCP auctions a defaulter to fellow active counterparties before the losses are experienced and majorly begins by terminating all financial transactions between a defaulting counterparty and other members. In the event the defaulter counterparty isn’t bought by the active members, a potential loss is spread across all the active counterparties which, in most instances, is severe.

In the cases where the initial margin and the defaulted fund contribution prove insufficient and/or the auction fails, the CCP has other financial resources to cover the losses. These financial resources are derived from the ‘defaulter pays’ approach as discussed below.

Collateral requirements are also put in place by CCPs to reduce losses in the event of default. This may be in form of cash or liquid assets such as Treasury bonds.

CCPs apply the ‘defaulter pays’ approach where the clearing member pays all necessary funds to stand for potential default. This, however, is impractical. From this approach, the financial contribution by each member is to cover the losses in the event of default. In scenarios where the initial margin and the default fund contributions have been exhausted by the CCP, further losses may be taken from some contributions in what is known as the ‘skin in the game’, but at this point, the CCP would still operate normally.

CCP reduce margin period of risk by making daily and potentially also intraday collateral in cash only.

They also have full authority over all the calculations and ensure that members can adhere to the operational requirement of posting collateral and that they guarantee to post on behalf of clients if necessary.

Comparing Bilateral and Central Clearing

Only standardized, un-exotic, and liquid products can be cleared.

CCPs impose strong collateral requirements on its members compared to bilateral markets.

In CCP markets, capital charges are relatively moderate and relate to trade levels and default fund exposure whereas, in bilateral markets, the participants are exposed to default risk.

In central clearing, there is a centralized auction in a default scenario while a bilateral market auction is unusually uncoordinated.

In bilateral markets, the costs come from counterparty, funding, and capital risks, whereas in the CCP markets, the costs are mainly funding risks.

Advantages and Disadvantages of CCPs


  1. Transparency: Bilateral markets lacks knowledge of exposure faced by institutions while CCPs have diverse information
  2. Offsetting: Transactions between counterparties in a CCP can be offset while, in bilateral markets, it is impossible to offset transactions
  3. Loss mutualization: In the event of default by a counterparty, the loss is distributed among the counterparties making the effects less dramatic.
  4. Legal and operational efficiency: CCPs are efficient and less dramatic in the event of legal issues being that it’s centralized.
  5. Liquidity: In CCP markets, there is an increased ability to trade combined with the multilateral netting benefits and limited barriers in entering the market.
  6. Default management: In CCP markets, the auction is centrally managed hence cheaper while, in bilateral markets, the auction is uncoordinated.


  1. Moral hazard: Counterparties have a limited ability to monitor each other’s credit quality and act properly because a third party is bearing all the responsibilities.
  2. Adverse selection: Counterparties with more information on the associated risks of a transaction than the CCP pass the more risky products to the CCP.
  3. Bifurcations: These results from a mismatch between cleared and non-cleared trades.
  4. Procyclicality: This refers to the positive dependence with the state of the economy. CCPs may increase collateral requirements during a crisis or in a more volatile environment.

CCP Capital Charges

There exist CCP-specific capital charges that reflect the fact that CCPs are not risk-free and the contribution to the default funds can create losses without the CCPs failing.

CCP capital requirements for qualifying CCPs (QCCPs) come in two forms:

  • Trade Exposures: Arise from current market to market exposures, variation margin, potential future exposure (PFE), and also the initial margin posted to the CCP. It is only at risk in the event of failure or collapse of the CCP and not its members. It is normally driven by a significant quantity of initial margin required by a CCP.
  • Default Fund Exposure: This covers the exposure through the contributions made to the CCP default fund which is at risk even if the CCP doesn’t default. The members are at risk of losing their funds in the event of CCP projecting losses or in the event a counterparty has defaulted. Contributions to the default fund by each CCP complicates it further and thus implies that each CCP will present a specific risk. The regulatory formula is thus considered a one-to-one capital charge in that, although default fund contributions are relatively small compared to initial margin requirements, it is quite punitive.

What Central Clearing Means For xVA

Central clearing of OTC derivatives is aimed squarely at reducing counterparty risk by the risk management practices of the CCP, in particular with respect to collateral they require. This implies that CVA and associated capital charges would no longer be a problem when clearing a CCP. However, two issues arise from the above view:

  1. First, counterparty risks and funding and capital issues (CVA, FVA, and KVA) predominantly arise from uncollateralized OTC derivatives with non-financial end users. As a result, such end-users will be exempt from the clearing mandate making them not to move to central clearing except on a voluntary basis. Being that most such end-users find it difficult to post collateral, voluntary clearing is impossible making uncollateralized bilateral transactions that are most important from the xVA perspective persist as such.
  2. Secondly, central clearing and other changes such as the incoming bilateral collateral rules may reduce components such as CVA, but will also increase other components, i.e., FVA and MVA. Therefore, it becomes necessary to understand xVA holistically in order to understand the balance of various effects.

Practice Questions

1) Which of the following are advantages of central counterparties?

  1. Loss mutualization, adverse selection, and legal and operational efficiency
  2. Offsetting, liquidity, and bifurcations
  3. Legal and operational efficiency, moral hazard, and bifurcations
  4. Default management, liquidity, and loss mutualization

The correct answer is D.

Default management, liquidity, loss mutualization, offsetting, and legal and operational efficiency are all advantages of CCPs.

Disadvantages of CCPs include moral hazard (counterparties have a limited ability to monitor each other’s credit quality), adverse selection(counterparties pass the more risky products to the CCP), bifurcations (mismatch between cleared and non-cleared trades), and procyclicality(the positive dependence with the state of the economy).

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