Recently, a large U.S. companyexecuted a sizable portfolio of cross-currency derivatives to hedgeits international exposure. As it evaluated prospective swapstrading partners, the company—let's call it XYZ Corp.—was surprisedby both the size and the variance in credit-charge markups proposedby the different banks. It was also concerned about the significantcredit risk posed by some of the banks and was unsure how best tomanage this exposure.

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When XYZ had executed derivatives trades in the past,counterparty risk was not top-of-mind. Its discussions with bankstypically focused on two topics: market rates and how much markupthe banks would add to the market rates to compensate for XYZ'scredit risk and provide a return on capital. XYZ would typicallycompare the markups among its stable of swaps banks and award eachtrade to the lowest-cost provider.

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On the surface, this approach appeared to help XYZ select theprovider with the lowest price, but it had two critical flaws.First, it ignored the providers' relative credit quality; thecompany treated all counterparties as equal. Over the past severalyears, XYZ has begun to pay more attention to the counterpartyrisks posed by its banks, and in deciding which bank to award itscurrent swaps business, the company wanted to take the banks'credit profiles into consideration as it weighed their pricingdifferences. Second, XYZ's former approach to evaluating swapsproviders gave the banks the opportunity to show a competitivecredit markup to win the trade, with the intent of makingadditional profit by showing a less attractive “market rate” thanmight be available elsewhere in the market.

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XYZ managers decided that they needed a new approach toquantifying and pricing counterparty risk. They wanted to selecthedge providers based on each provider's all-in costs, includingthe bank's risk of default. They wanted to have better control overthe pricing discussion to ensure that they received the bestpossible market price. And they wanted to continue managing theircredit exposure to those providers for the entire life of theswaps.

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Companies Refocus on Counterparty Risk

The shift in XYZ's attitude toward credit exposure to its swapsdealers reflects a broader trend. Most companies are now payingmore attention to their banks' credit quality than they did adecade ago. The financial crisis highlighted the risks of defaultby a hedge counterparty. Banks' credit ratings have beendowngraded, which has reduced or eliminated the ratingsdifferential between banks and corporations. And bank creditspreads have widened relative to corporate spreads, reflecting themarket's view of increased risk of a bank default.

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At the same time, companies arefacing a material increase in the credit-charge markups for certaintrades, as well as greater pricing differences among banks. Marketforces are driving some of this change. Increased volatility in thecurrency and interest rate markets, along with the skewed riskprofiles that result from today's historically low interest rates,have increased the potential credit risk for trades such ascross-currency or interest rate derivatives. This increasedexposure for banks has, in turn, led to an increase in creditcharges. Costs have also been influenced by higher spreads oncredit default swaps (CDS), banks' ongoing refinement ofcredit-pricing methodologies, and increases in bank capitalrequirements that are complex and inconsistently applied. As aresult of all these developments, many companies have recognizedthat counterparty risk is not a one-way street in derivativestrades, and that they need to actively manage their tradingrelationships from both a pricing and a counterparty riskmanagement perspective.

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Historically, most companies used a fairly standard process toevaluate and manage their exposure to banks' credit risk. Theywould set exposure limits for each counterparty based on creditquality. They would allocate trades among counterparties to avoidconcentrated exposure, giving preferential pricing to certain banksin order to diversify their portfolio. The more sophisticatedcompanies would track each bank's credit ratings and CDS level, andmight include provisions in their trading documents that allowedfor early termination if the bank's credit rating changedsignificantly.

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In theory, if default by a bank counterparty became more likely,this process would enable the company to take action to reduce itsrisk. However, its efficacy is limited. First, as the LehmanBrothers bankruptcy illustrates, corporations cannot always actquickly enough to mitigate counterparty risk, even if theyrecognize an impending default. Second, this process does notaddress credit pricing inconsistencies, nor does it provide thecompany with a way to compare banks' prices on an apples-to-applesbasis.

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Because of these deficiencies, this straightforward approach maybe appropriate only for companies with limited exposures—forexample, companies with hedges such as rate locks or foreignexchange (FX) trades that are shorter than one year, wherecounterparty risk and credit charges are low. Companies that havelarger exposures, either as a result of longer tenors or largenotional amounts, should consider a more robust approach.

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Professional Market Approaches

Banks and other professional derivatives traders mitigatecounterparty risk using two different approaches. When working withsmaller financial services counterparties or corporate clients,many use sophisticated models that they've developed to evaluateand price risk. These models typically take into consideration thebank's potential credit exposure to the counterparty under theproposed trade and the impact of the trade on the bank's overallderivatives portfolio with that counterparty. They use a number ofinputs: the terms of the proposed trade; the credit terms of thebank's ISDA master agreement with the counterparty; an inventory ofall existing trades between the two counterparties, including termsand current mark-to-market (MTM) value; and credit spreads for thecounterparty, using the company's CDS or an index

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A bank uses its model to run simulations on a portfolio oftrades under a variety of market scenarios. Then the bank uses theresults of these simulations to calculate its potential exposure tothe counterparty over the lifetime of the trades. This type ofmodel can calculate credit charges for a proposed trade based onthe trade's marginal impact on the firm's overall risk position.Once the trade is executed, the bank can use the model's riskoutputs to construct an appropriate credit hedge using creditdefault swaps, though in many cases the bank relies on diversitywithin its counterparty risk book to neutralize its exposure.

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A few companies that engage in derivatives trades have taken acue from the banks and attempted to replicate the professionaltraders' models to calculate the cost of their banks' counterpartyrisk. This enables them to adjust each bank's proposed creditcharge to account for the company's cost of taking on creditexposure to that bank. However, companies face several substantialobstacles to using bank-style modeling. First, the underlyingmodels are complex; developing and maintaining them requires asignificant investment in technology and analytical resources.Second, once a company has a model, it needs to allocate resourcesto analyze the impact of each planned derivatives trade with everypotential counterparty, to determine the appropriate credit-chargeadjustment per counterparty. This could result in several hours ofwork per proposed transaction, depending on the number of potentialcounterparties and scenarios the company wishes to evaluate.Finally, a company's derivatives counterparty exposure is typicallyconcentrated within the bank sector, limiting any benefits fromdiversification. As a result, companies using this approach mustcontinue to dedicate resources to ongoing monitoring and managementof their credit exposure to each individual bank.

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Banks have historically found the modeling approach too complexand time-consuming to use for all counterparties. Furthermore, theamount of counterparty risk to be managed by the banks could exceedregulatory limits for certain counterparties, particularly thosewith whom they transact in a market-making capacity, such as otherdealers or institutional investors.

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In these situations, banks and their professional counterpartiesmanage risk using bilateral collateral arrangements, which aresimilar to margin requirements on an exchange. Notably, theDodd-Frank Act imposes margin requirements on most derivativesactivity, which will result in near-universal adoption of thisapproach by professional counterparties in the not-too-distantfuture.

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These arrangements typically involve daily posting of marginequal to the net MTM value of each firm's portfolio of trades witheach of its counterparties. Margin is typically held either by theparty to which it was posted or by a third-party custodian orclearinghouse, depending on the terms of the collateral agreement.This collateral effectively neutralizes counterparty exposure forthese trades, creating an environment in which market makers canoffer a single market price that is available to all marginedcounterparties, without the need to adjust for credit charges orworry about credit capacity limits.

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Pros and Cons of Margining

Some companies, particularly those that find the modelingapproach burdensome, may wish to consider collateral arrangements.Incorporating margin requirements into derivatives tradingdocumentation enables a company to reduce its counterparty creditexposure, and it creates a level playing field among prospectivebank counterparties. This means the company doesn't need to assesseach bank's credit risk and then weigh its proposed markups inlight of that exposure. In fact, margin requirements have thepotential to eliminate banks' credit charges altogether.

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The obvious downside of placing margin requirements onderivatives trades is that cash becomes tied up as collateral insupport of the trades. A company following the professionalmargining model must not only commit collateral equivalent to theinitial market value of the trade, but must also be ready toincrease or decrease the collateral on a daily basis to reflectchanges in the derivatives' value. An MTM-based collateralarrangement may result in significant capital calls arising fromchanges in market rates that are beyond the company's control. Thisrisk is likely to concern companies that are unaccustomed to suchswings in funding requirements. Managing margin also places addedoperational demands on the treasury function. As a result of theseconsiderations, an MTM-based margin arrangement is best suited tocompanies that transact several times a year, execute swaps withtenors greater than one year, have ample access to liquidity, andhave sufficient treasury staff to support margining operations.

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To address operational and liquidity concerns, companies mayprefer to adopt margin provisions that strike a balance betweenmitigating risks and substantially increasing demands on thetreasury function—in essence, moving from a “fully collateralized”trading relationship to one that is partially collateralized. Forexample, a company and its counterparty may agree to a marginthreshold, which would eliminate the need by either party to postmargin until the MTM value of the company's swaps portfolio withthat counterparty exceeds a predetermined value. Or the company andits counterparty may agree to assess margin requirements on aweekly basis, instead of daily, which reduces by 80 percent theamount of time spent managing margin, though this approach wouldexpose the company and its counterparty to more meaningful swingsin MTM between valuation dates.

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By modifying the terms of a fully collateralized marginagreement, a company would forgo some of the credit protection andpotential pricing benefits of a fully margined agreement inexchange for reducing the operational or liquidity burden thatmargining places on the organization. Companies can also managemargin needs through careful distribution of transactions amongtheir counterparties.

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Credit Where Credit Is Due

At the end of the day, there is no “one-size-fits-all” solutionfor companies seeking to manage bank counterparty exposure. Thevast majority of companies continue to use a traditionalcredit-monitoring approach to mitigate counterparty risk inderivatives trading. The use of either a modeling or marginingapproach is growing, however, with some of the largestmultinational firms leading the charge. And while regulators do notcurrently impose margin requirements on corporate end users ofderivatives, companies may soon find that some banks won't offercertain types of trades, such as long-dated FX transactions, iftheir counterparty refuses to post margin. This is because BaselIII capital rules require banks to allocate large amounts of riskcapital to these types of trades if they're transacted on anunmargined basis.

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Companies can reap substantialrewards using margining in derivatives trades, even if margin isn'trequired. This is the path that XYZ Corp. pursued. That companydetermined that the up-front reduction in credit charges—whichaccounted for tens of millions of dollars over the life of thetrades—would more than offset the potential cost of increasedliquidity, while addressing the company's risk managementconcerns.

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An organization that implements a margin agreement, particularlya fully margined trading document, regains control of the pricingdiscussion. No longer does the bank's markup for credit, or thecompany's desire to diversify bank counterparty risk, drive itsselection of hedge providers. As XYZ found, companies withmargining agreements can award trades to the banks offering thebest market price.

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End users need to carefully consider all available tools formanaging counterparty risk and select the approach that best suitstheir needs. Whichever approach a business chooses, it should onlygive credit where credit is due, and ensure it gets credit inreturn.

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ChristineGinfrida is a director of advisory services forEA Markets LLC, acorporate finance and capital markets advisory firm based in NewYork City. Ginfrida has more than 15 years of experience instructured products origination and derivatives marketing. She haspreviously worked for Citigroup, JPMorgan, and Merrill Lynchproviding interest rate, currency, and credit risk managementadvisory services.

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