Managing Counterparty Risk

Date: January 2009
Author: Ian Yuill  
Price: £750 to non-members of the Investit Intelligence Member service  

Fund managers have devoted a lot more attention to counterparty risk in the past 12 months. The reasons for this are all too apparent; the liquidity crisis led to the collapse of several organisations including Bear Stearns, Northern Rock, HBOS and of course, Lehman Brothers.

This situation is likely to continue. Financial organisations are wary of putting themselves in a position where they are exposed to other firms. This is likely to be exacerbated by the current economic downturn. Fund managers with exposure to banks through market transactions, FX trades, OTC derivatives, treasury investments, stocklending and custody had become accustomed to a more cursory counterparty risk management strategy. Typically this focused on the approval of new counterparty relationships and infrequent exposure reporting.


This research looks at the steps that fund managers have taken to improve counterparty vigilance, for example:

  • Strengthening counterparty credit committees with increased senior representation.
  • Designing and implementing processes to enable firms to reduce counterparty exposure.

The report then looks at the underlying problems and challenges that firms currently face when producing exposure information and analyses the strategies and vendor systems that are available to help them.

Having established a set of current market standards our research then sets out the best practice principles for managing counterparty risk. In some respects best practice really equates to ideal practice standards as counterparty risk has only become a high profile activity within buy-side firms relatively recently.

In contrast, the sell-side has devoted considerable attention to counterparty risk management. Sell-side firms have typically invested heavily in systems and processes to manage counterparty risk. We describe lessons buy-side firms can learn from the sell-side and just as importantly the mistakes that should not be repeated.


Table of contents

  Management Summary 1
1.0 Introduction 3
  1.1 Scope 4
  1.2 Methodology 5
  1.3 What is counterparty risk? 7
2.0 Market Practice in Counterparty Risk Management 9
  2.1 Setting up a counterparty risk infrastructure 10
  2.2 The counterparty approval process 12
  2.3 Calculating exposure 14
  2.4 Determine counterparty credit worthiness 21
  2.5 Setting counterparty limits 24
  2.6 Mitigating counterparty risk 27
  2.7 Computer systems 29
  2.8 Outsourcing counterparty risk 31
3.0 Best Practice Model for Counterparty Risk 33
  3.1 Lessons from the sell-side 34
  3.2 Establishing a risk-aware culture 36
  3.3 Creating a counterparty risk management committee 37
  3.4 Assessing counterparties 39
  3.5 Monitoring counterparty exposure 42
  3.6 Implementing risk reduction strategies 44
  3.7 IT systems 46
  3.8 Maintaining focus on counterparty risk 50
4.0 Challenges of Managing Counterparty Risk 53
  4.1 Aggregating exposure data 54
  4.2 The difficulties of measuring counterparty risk for different asset classes 57
  4.3 Infrastructure immaturity 58
5.0 Counterparty Risk Case Study 59
  5.1 First steps 60
  5.2 Client reaction 64
  5.3 Impact on counterparty risk process 65
  5.4 Long term impacts 67
6.0 Some Conclusions 69
  6.1 Drivers for change 70
  6.2 Market initiatives 72
  6.3 Does counterparty risk management provide a competitive edge? 73
  6.4 What does the future hold? 75


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