Survey of the OTC Derivatives Market in Australia – May 2009 4. Counterparty Credit Risk Management

A central objective of the Survey was to better understand the risk-management practices adopted by participants in Australia's OTC derivatives market, particularly in respect of counterparty credit risk. OTC derivatives contracts are typically of long duration and involve continuing obligations throughout the life of the contract.^[1] Counterparty credit risk is the risk that these obligations will not be fulfilled. Participants in the OTC derivatives market generally manage this risk in a number of ways, including through:

• due diligence and counterparty approvals;
• the agreement of robust legal documentation; and
• the collateralisation of exposures.

This section considers Survey responses relating to each of these counterparty risk-management practices, drawing out the implications of an increased emphasis in recent times on risk-management issues, both internally within respondent firms and across the industry. For instance, according to Survey respondents, recent events have reinforced a trend over time towards use of industry-standard legal documentation, and the conclusion of collateral agreements with counterparties.

4.1 Due diligence and counterparty approvals

Survey responses reveal broad consistency in respondents’ due diligence and counterparty approvals processes. Key features include the following:

• The due diligence and counterparty approvals process is carried out by non-trading staff, generally from ‘middle-office’ risk-management units, or client-relationship teams. Internationally active banks typically follow group-level guidelines for bringing new clients on board and setting trading limits, in some cases submitting recommendations to head office for approval.
• Respondents typically vary the scope and intensity of counterparty credit assessments according to the type of counterparty and the nature of the business to be conducted under the relationship. The approvals process does not differ systematically across products.
• Consideration is given in the due-diligence process to the ‘know your customer’ obligations under the Anti-Money Laundering and Counter-Terrorism Financing Act 2006 (AML/CTF Act).
• Several respondents, mainly domestic banks, noted that they required counterparties to adhere to AFMA codes and conventions.
• Trading and exposure limits typically reflect a mix of economic and financial indicators (eg, balance sheet ratios; current and forecast profitability; industry factors); and non-financial indicators (management quality, business strategy, reputational risk and any evidence from prior business relationships).
• Some respondents referred to separate processes for the approval of internal or affiliated counterparties.

There is some evidence that buy-side respondents place greater weight than sell-side participants on the judgements of credit-rating agencies in their initial evaluation of potential counterparties.

Survey responses also indicate that, due to the events of the past 18 months, middle- and back-office risk-management and processing units have gained influence within institutions, often at the expense of risk-generating front-office units. Not only have counterparty relationships become subject to increased scrutiny, but there has also been a greater emphasis on timely reporting of risk positions to assist senior management in decision making.

4.2 Documentation

Sell-side respondents made reference to clear internal policy guidelines around the establishment of legal documentation to underpin OTC derivatives contracts. In accordance with international practice, trades in the Australian market are typically executed according to the provisions of Master Agreements developed by the International Swaps and Derivatives Association (ISDA). These agreements specify close-out provisions should a counterparty default, and increasingly include a Credit Support Annex (CSA), detailing the contracting parties’ collateral-posting obligations (see Box 1). Some respondents also cited occasional use of other forms of documentation for certain products or counterparties, reflecting the bespoke requirements of particular counterparties or industry segments. Importantly, where other forms of agreement are negotiated, they also include the critical provisions around close-out procedures.

Respondents typically aim to have a Master Agreement or other appropriate legal documentation in place prior to trade. In some cases, however, there may be a delay in completing the relevant legal processes – perhaps where dealing with a less sophisticated client, or one that does not have internal legal expertise – and a management decision may be taken to execute a trade without completed documentation. In such circumstances, respondents typically take one (or more) of the following steps to mitigate legal risks:

• require a ‘long-form’ confirmation, referencing ISDA terms: while this may lengthen the time-frame for confirming a trade, a long-form confirmation seeks to minimise legal risk by ensuring that key close-out provisions are established for the trade;
• restrict the size or duration of contracts executed without documentation: for instance, lower counterparty exposure limits may be implemented for trades that are not supported by appropriate documentation, or trades may be restricted to very short maturities; and/or
• include, in a long-form confirmation, provisions for early termination if documentation is not completed on a specified time-frame: such provisions protect the counterparties in the event that a legal agreement cannot be reached.

Respondents also often made reference to documentation-management systems to assist in monitoring and tracking progress towards completion of relevant legal documentation. These systems are sometimes applied globally for large overseas banks.

Generally, respondents perceive an increasing acceptance of the importance of timely completion of robust legal documentation to support trading in OTC derivatives products, and a discernible increase in counterparties’ willingness to negotiate terms. Some higher rated sell-side respondents noted that, in light of recent financial market turbulence, they had been able to negotiate more stringent provisions for early termination of contracts in response to specified ratings downgrades, thereby enhancing their capacity to manage counterparty credit risks. All sell-side respondents that actively trade credit derivatives have also signed up to the recent ISDA Auction Hardwiring protocol, which took effect from 8 April 2009 (described in Box 1).

4.3 Collateralisation practices

A CSA sets the terms for payment and receipt of mark-to-market margin, ie, the transfer of collateral to reflect mark-to-market losses following a change in prices. A CSA may allow for some flexibility in mark-to-market payments, by setting an unsecured threshold, ie, a threshold below which mark-to-market margin need not be paid. A minimum transfer amount, ie, a minimum dollar value for cash transfers between counterparties, may also be applied to avoid costs associated with settling small mark-to-market payments. The calibration of unsecured thresholds and minimum transfer amounts typically reflects the financial standing of the counterparty. Most respondents indicated that mark-to-market valuations were calculated internally on a daily basis, in some instances with verification by an external third party.

Consistent with international evidence, most CSAs negotiated with corporate, financial and institutional clients are two-way agreements. On average, sell-side respondents reported that around 75 per cent of their CSAs were two-way, although significant variability was observed, especially among overseas banks. One-way agreements in the sell-side bank's favour typically apply for hedge funds, structured funds and smaller financial intitutions, while one-way agreements in the buy-side counterparty's favour are often negotiated in the case of governments and supranationals. Also consistent with international evidence, the vast majority of collateral is posted in the form of cash, the remainder taking the form of high quality (typically government) debt securities. Of the 15 sell-side bank respondents to the Survey, 12 – including all of the domestic banks – reported that cash made up at least 80 per cent of collateral posted and received. Seven respondents reported 100 per cent cash collateral.

CSAs do not ordinarily provide for the payment of initial margin (ie, margin called up-front to cover a potential adverse price move before a defaulting counterparty's position can be closed out), but may do so in the case of smaller/weaker counterparties. Some respondents indicated, for instance, that hedge funds were often required to post initial margin.

According to the Survey, CSA coverage varies widely in the Australian market, ranging from a low of five per cent to a high of 95 per cent depending on the particular OTC product. Buy-side participants tended to cite lower levels of CSA coverage than sell-side banks. Some of the sell-side respondents with relatively low reported levels of coverage noted that the headline figures masked considerable divergence across counterparty types. In particular, they observed that CSAs were generally in place for the vast majority of financial counterparties, while coverage was typically lower among corporate counterparties. Furthermore, priority was given to negotiating CSAs with those counterparties generating the largest exposures.

One explanation for the absence of CSAs for certain corporate clients and industry segments is the potential liquidity and cash-flow implications of mark-to-market margin calls. Where counterparties are liquidity constrained, calling for collateral could exacerbate an adverse shock. Therefore, while generally appropriate for financial counterparties or corporates with relatively unconstrained access to cash liquidity or collateral-eligible securities, collateralisation may not be the optimal risk-management approach for all counterparty types.

Respondents cited a number of alternative risk mitigants for these counterparties, including the following:

• position/exposure limits;
• termination and right-to-break clauses in the Master Agreement; and
• negotiation of a charge over balance sheet assets.

Where collateral agreements are in place, counterparties must have the capacity to carry out mark-to-market valuations and process the delivery and receipt of cash or collateral securities. Collateral management systems are typically used to assist in the management of these processes, with many sell-side participants citing the use of systems provided by external vendors. Collateral disputes occasionally occur, often reflecting valuation mismatches and/or end-of-day timing differences. Recent targeted APRA reviews indicate that there has been progress in ensuring that procedures have been established to resolve such issues.

Survey evidence on the evolution of collateralisation practices in Australia is broadly consistent with international findings in ISDA's latest Margin Survey, which reports continued expansion of collateral coverage (both in terms of the volume of trade subject to CSAs and the overall quantum of credit exposure covered by collateral agreements). Indeed, notwithstanding the cash-flow and liquidity considerations cited above, sell-side respondents have observed an increased willingness on the part of counterparties to negotiate CSAs. Given recent market developments, both buy-side and sell-side participants accept the need for sound practices in this area.

There has also been a general tightening of margin requirements: unsecured thresholds have been negotiated downwards (often to zero), as have minimum transfer amounts. Some respondents also cited an increase in the application of initial margin requirements, or where pre-existing, an increase in the level of coverage.

Footnote

For instance, in a credit derivatives contract, the seller of credit protection has an ongoing obligation, over the life of the contract, to pay a contracted sum to the buyer of protection in the event of a default by the reference entity. The buyer of protection, in turn, has an obligation to pay its quarterly premia to the seller. [1]