By Terry Flanagan

Clearing To Ease Counterparty Risk

Central clearing of OTC derivatives will greatly improve the process of collateral management by removing the labyrinthine tasks associated with calculating counterparty risk on bilaterally negotiated agreements. There’s a catch, however: the collateral that CCPs and futures commissions merchants (FCMS) maintain on behalf of individual customers needs to be kept speared from that of other customers for it to work.

“Margin collateral for cleared swaps should be legally segregated, as the CFTC is proposing,” David Kelly, director of credit products at Quantifi, told Markets Media.

Under a scheme proposed by the CFTC, called legal segregation with operational commingling or LSOC, each derivatives clearing organization (DCO) and FCM must segregate the cleared swaps of each individual customer. Operationally, however, FCMs and DCOs are permitted to commingle the relevant collateral in one account. Each FCM and DCO must ensure that such account is separate from any account holding FCM or DCO property or property belonging to non-cleared wasps customers.

In the interbank market, legislation such as the Dodd-Frank Act and European Markets Infrastructure Regulation (EMIR) mandates central clearing and collateral as the principal means for managing counterparty risk.

In the corporate derivatives market, however, uncollateralized exposure is far more prevalent, and banks compete aggressively on credit value adjustment (CVA) pricing; a CVA is the monetized value of the risk of default by either counterparty to a transaction.

The need to calculate credit value adjustments (CVA) and exposure metrics on a portfolio adds substantial analytical and technological challenges. Hence, the move to central clearing promises to alleviate the headaches associated with CVA, provided that the LSOC model is adopted.

A significant benefit of clearing is that it transfers counterparty risk out of extremely complex CVA and economic capital models and into much simpler margining formulas. “The relative simplicity of clearing/margining is fully dependent on the availability of the collateral held against positions in the event of default by the FCM and/or its customers.”

If there is any risk that the collateral held against a certain position may not be available due to commingling or the ability for a DCO to access collateral posted by non-defaulting counterparties, then

“clearing/margining presents complex collateral risks that are arguably as complicated as uncollateralized counterparty risk,” Kelly said. “LSOC minimizes collateral risk and preserves the important benefit of analytical simplicity and risk transparency.”

Quantifi’s CVA technology, called Quantifi Counterparty Risk, incorporates high-performances, multifactor Monte Carlo simulation, combined with a grid computing architecture. The product supports calculation of CVA sensitivities and incremental deal pricing, enabling banks to proactively manage counterparty risk.

Regulations will have a substantial impact on risk management. According to a survey of sellside and busydie professionals conducted by Fincad, accurate risk assessment was found to be the greatest challenge.

In response, respondents reported adjusting their risk management strategies, including greater analysis and awareness of model risk, stress testing and scenarios analysis. The most important type of risk analysis was Monte Carlo VaR for both sell-side (31%) and buy-side (40%) survey participants.

Accurate risk assessment is a critical component to overall risk management strategy, according to Bob Park, CEO of Fincad. Knowing your solution provides the right numbers is vital to an organization’s ability to manage their risk.

Fincad’s F3 technology provides portfolio level risk analytics, including CVA and Monte Carlo VaR. F3’s Universal Risk Technology provides first-order sensitivities on-demand, eliminating the need for resource-intensive bumping. (Bumping is a method used to approximate the sensitivity of a portfolio to changes in underlying market variables.)

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