Counterparty Risk in Focus

Terry Flanagan

Counterparty risk, or the risk that a financial institution involved in a securities transaction won’t fulfill its obligations, remains a primary concern among asset managers, almost five years since the global financial crisis.

Managing reserves and hedging costs and strategies is most critical in turbulent times, but it’s also an important day-to-day challenge for hedge funds and other alternative managers in steady markets. System controls, a strong internal risk manager, and intensive due diligence are some specific requirements, according to market participants.

“You don’t know the counterparties to the counterparties,” Ram Ahluwalia, portfolio manager at Winged Foot Capital, said at an industry event. “This illustrates the problem of counterparty risk. Institutions have to post more collateral to plug the liquidity drain, especially in periods of financial distress.”

In reviewing counterparties’ structure and capital, some investors lean on ratings agencies, while others say the agencies are outmoded. “The ratings agencies have not touched their models since the 1980s” and their process lacks transparency, one chief investment officer said.

Proffered guidance for better counterparty risk management included finding an asset manager that acts as a fiduciary and making sure there are no principal agent problems, selecting managers with multi-prime capabilities, and establish advanced rehypothecation agreements for easier recovery.

For short-term funding lines, some counterparties will be willing to incur a negative carrying cost so they will have liquidity and cash on hand in times of stress. Dealer inventory impacts liquidity, so look at incentives in falling markets as a possibility, one panelist suggested.

Technical aspects of mitigating exposure when things happen were emphasized.  John Lloyd, Traiana’s director of product strategy, said they’ve built integrated kill switches and utilize technology to spot abnormalities in trading patterns, and to facilitate routing and delivery functions for central counterparty clearing.

Central clearing’s overall effectiveness in risk mitigation was discussed. “Clearing houses have a top-down model for transferring risk,” Ahluwalia said. “This does not eliminate it.”

Noting you can’t manage what can’t be measured, Ahluwalia said margining is key, though it remains a vexing part of the credit-risk computation.

The regulatory-driven movement towards central clearing will make things more fluid, but it will not necessarily avert or stem a crisis, panelists noted. Emerging and frontier markets are a different story, as regulation can be too much or not enough, and taxation can be onerous.

2100 Xenon develops quantitative models for emerging-market investing. “When markets are newer, inefficiencies make them more profitable,” said Jay Feuerstein, the hedge fund’s chief executive. “But then you can get charged back extreme commissions and taxes.”

Hedge fund Rebellion Research, which manages data from 44 countries, has seen how fast geopolitical and sovereign debt upheaval can turn a market. Chief executive Alexander Fleiss reported that as with recent events in Egypt, Brazil, and Turkey, “the whole country can turn into a nightmare in a week.”




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