From the September 2010 issue of Treasury & Risk magazine

The Counterparty Challenge

The recession may be abating, but the need for fully transparent and up-to-date counterparty risk assessment is more critical than ever.

Steve Bullock is senior vice president and general manager for North America for IT2 Treasury Solutions. In addition to working for 10 years with treasury software providers in Europe and the U.S., he also spent 14 years in Aon's corporate treasury in London, in front office dealing, FX exposure management and hedging, and bank relationships.

Just when treasury's focus seemed to shift slightly away from counterparty risk management, the Greek and then the Hungarian sovereign debt crises blew up, showing once again that extreme events such as the collapse of Lehman Brothers or a sovereign debt crisis ought not to be discounted. Treasury best practice seems to demand that counterparty risk management stay at the top of priority lists and that treasurers remain constantly vigilant for sudden credit deterioration. New models are emerging to help with that task, as well as better ways to use integrated technology.

T&R: What has changed?
Bullock: Credit limit and counterparty exposure management in the past were seen as important, but essentially routine. Since the crisis, it's clear that all the disciplines of treasury risk management are interrelated, and the common factor is counterparty risk. This is because the current and projected valuations of financial instruments in fact depend on the creditworthiness of the counterparty. The crisis showed how important it was that these areas were connected and analyzed in one coherent risk management process. The reality that major banks could in fact fail brought credit risk into prominence.

T&R: How are treasurers adapting?
Bullock: Treasury risk management has become more complicated and demanding. Many departments have introduced alternative and supplementary techniques, for example, monitoring CDS (credit default swap) spreads. A CDS is a swap contract in which the protection buyer of the CDS makes a series of premium payments to the protection seller and, in exchange, receives a payoff if a credit instrument (typically a bond or loan) goes into default. CDSs are similar to buying insurance against a default or covered credit events. The protection buyer pays a default swap premium. In essence, CDS spreads are very sensitive to the market's expectation of the likelihood of a given counterparty defaulting. For example, Lehman Brothers carried an investment-grade A rating from Standard & Poor's when it collapsed, while its market-sensitive indicators--such as Lehman's equity price--showed a relentless decline in value for the six months leading up to the actual failure, but Lehman Brothers' CDS spread deteriorated by 600 basis points in the week preceding its collapse.

Very few treasurers actually use CDSs as hedging instruments--they are probably too volatile for corporate use. But this very volatility makes the spreads such a useful leading indicator of changes in creditworthiness. Companies track CDS spreads--and if they indicate change, they can then act to unwind positions and transact new hedges as required. Using CDS spreads for credit risk monitoring is recommended by the Association for Financial Professionals. Other indicators of probability of default are: equity and bond prices, volatilities and indices, probability-of-default factors published by specialist organizations, market capitalization, and working capital factors, but none of these looks likely to supplant CDS spreads.

T&R: What about fair value measurement?
Bullock: This may be defined as the measurement of the price that would be received if an asset were sold, or the amount that would be paid to transfer a liability, in an orderly transaction between market participants at the measurement date. In cases where market value is not derived from an objective, transparent source, fair value is derived by applying a credit valuation adjustment (CVA) to market value. CVA calculation requires measurement of a hedge counterparty's probability of default, which in the U.S. is usually derived using CDS spreads.

When CVA is applied (as required under FAS 157), the effect is to apply a risk factor that is designed to make the fair value statement more conservative--and also more consistent and comparable. In practice, this can have interesting effects: two interest-rate swaps with identical terms and cash flows will have significantly different fair values if the swap counterparties have different creditworthiness, with one requiring application of the CVA.

T&R: What is the role of technology?
Bullock: A fundamental requirement is the measurement of the net exposure to a counterparty. This involves combining all relevant components of a company's total net exposure to a given counterparty--deposits, investments and derivatives of all kinds--so that they can be accurately managed and monitored. Technology is essential if this information is to be reliably maintained and readily available. Market values such as CDS spreads and equity prices used to monitor counterparty credit are changing constantly. This means that treasuries' analysis should be synchronized with the markets for maximum effectiveness. Technology provides an automated link between market values (for example, via Reuters or Bloomberg) and the central treasury database, and performs the required calculations.

The frequency of updating (real time, or periodically on a schedule, or on demand) depends on each company's perception of the sensitivity and level of risk it is carrying. But the key is having up-to-date and complete information available to monitor changes in counterparties' creditworthiness and to recalculate CVA values. Properly applied technology allows treasury to focus on its role of making risk management decisions and not worry about routine data collection, verification and processing.

Technology can also support automated counterparty limit management. Monitoring counterparty credit requires a lot of work behind the scenes, continually or at least regularly evaluating creditworthiness by automated processes, so that change can be properly tagged and managed.

By automating and streamlining how financial risk is measured, processed and reported, treasurers can accurately assess, predict and share their information with fellow team members and with management, right up to board level. And, the financial management of the whole enterprise is strengthened by virtue of the higher levels of risk and exposure transparency.

T&R: What other advances are on the horizon?
Bullock: As the world economies negotiate a rather shallow recovery, companies that can best manage their funding and working capital needs through effective forward-looking risk analysis can gain a competitive advantage in a tight credit environment that is likely to continue. This can be achieved by applying credit analysis internally and by monitoring external indicators such as equity price and the tone and content of analysts' reports.

Sophisticated (and technologically demanding) risk management techniques around Value at Risk (VaR) and scenario analysis, found today at financial institutions, could be adopted by the corporate sector in a new understanding of treasury best practice. If so, heavy technology support would be required to manage vast data volumes and complex computations.

The new, more public role of corporate treasury requires not only that it be more effective but that it be seen as striving for and achieving best practice. Treasury and finance are under closer-than-ever board scrutiny to demonstrate that their operations are not only efficient but well-controlled, clearly and currently documented and able to measure, analyze and report financial risk in a timely, reliable manner.