CSAs--regulating counterparty risk through the use of collateral payments.

• Author: Molland, Jermund
• Position: Report

1. Introduction

   Trading in financial instruments involves counterparty risk. From trade date until settlement date, a party to a trade will face a risk that the counterparty will default on his end of the contract. A change in market conditions can make substitution for a market trade costly (substitution cost). Since the risk of both substantial market volatility and counterparty uncertainty increases over time, counterparty risk is greater the longer the time between trade date and settlement date. This is primarily the case for various kinds of "long-dated" derivatives trades.

   In foreign exchange trades, counterparty risk is, all else being equal, greater than in trades involving only one currency. In addition to counterparty risk associated with changes in market conditions, as mentioned in the preceding paragraph, a currency trade will also be subject to counterparty risk associated with the settlement of the trade. Foreign exchange trades take place in principle in two independent payment systems, and there is a risk of being obliged to deliver currency that has been sold before receiving confirmation of receipt of currency bought. This involves uncertain exposures and a risk of losing the principal of the trade. Nevertheless, the launch of the CLS currency settlement system in 2002 has eliminated most of the risk associated with currency settlement. Settlement risk associated with foreign exchange trades will not be discussed further in this article.

   Market participants manage their counterparty risk by their choice of counterparties and instruments and maturities of their trades. Beyond this, risk can be mitigated by the use of central counterparties or bilateral margin agreements, called credit support annexes (CSAs).

   A central counterparty (CCP) is an entity that interposes itself between buyer and seller. Traders will then be exposed only to a single counterparty. Strict requirements have been set for risk management at a central counterparty (2). By interposing itself in a trade, a central counterparty mitigates the risk of counterparty insolvency prior to settlement or of changes in market conditions that prevent a counterparty from honouring the contract. For standardised exchange-traded derivatives, the use of central counterparties is common. On the other hand, traders are free to decide whether to use central counterparties for over-the-counter (OTC) derivatives. According to BIS (2010) the notional amount of outstanding global exchange-traded derivatives was around USD 70 trillion as at December 2010, while as at the same date the equivalent measure of OTC derivatives was estimated to be USD 600 trillion. In the wake of the financial crisis, it has been discussed whether to make use of central counterparties obligatory for all standardised derivatives transactions. The G20 reform agenda, aimed at strengthening the safety and resilience of financial markets, includes requiring all standardised OTC derivatives trades to be centrally cleared and reported to trade...