Counterparty Risk

Workflow A: Assessing a New Counterparty

1. Identify the legal entity and verify netting enforceability. Map the exact legal entity (not the corporate group), its jurisdiction, and entity type. Confirm close-out netting enforceability via ISDA netting opinions for that jurisdiction and entity-type combination before counting any netting benefit — where enforceability is uncertain, risk and capital must be measured gross. Apply the sovereign ceiling for counterparties in jurisdictions with material sovereign risk.
2. Assess credit quality from three angles. External ratings are a baseline but a lagging indicator — they typically reprice after the market has. Internal scoring: for banks, focus on CET1 (strong banks hold >12%), leverage ratio (well-capitalized banks target 5%+), LCR/NSFR (minimum 100%), and NPL trend; for corporates, debt/EBITDA, interest coverage (below 2x signals stress), free cash flow, and Altman Z-score, plus qualitative factors (management, franchise, regulatory standing). Market-implied: CDS spreads react fastest — annual PD ≈ CDS_spread / (1 − recovery); a 200bp spread at 40% recovery implies roughly 3.3% annual default probability.
3. Determine the trading channel: cleared vs. bilateral. Standardized interest rate swaps in major currencies and index CDS must clear under Dodd-Frank Title VII / EMIR (end-user hedging exemptions exist). Non-mandated products stay bilateral under the uncleared margin rules: zero VM threshold, IM threshold up to $50 million per counterparty group, and IM held segregated at a third-party custodian with no rehypothecation. Client clearing adds clearing-member risk: evaluate portability provisions and maintain a backup clearing member.
4. Negotiate documentation. ISDA Master Agreement (the 2002 version uses the Close-out Amount methodology; many legacy relationships remain on the 1992 version's Market Quotation/Loss — know which governs each relationship), Schedule elections (governing law, Specified Entities, cross-default thresholds, additional termination events such as NAV triggers), and CSA terms: threshold, minimum transfer amount, independent amount/IM, eligible collateral and haircuts, valuation frequency (daily is standard), and dispute resolution. Link the CSA threshold to ratings so it steps down — ideally to zero — on downgrade.
5. Set the credit limit. Tier by credit quality, with sub-limits by product and tenor (long-dated exposure is more uncertain) and a settlement limit separate from the pre-settlement limit. Apply explicit add-ons or reduced limits for wrong-way risk, where exposure and counterparty credit quality are positively correlated (general WWR: PD correlated with market factors; specific WWR: structural, e.g., a put written on the counterparty's own stock).
6. Stand up measurement and monitoring. Compute current exposure CE = max(V, 0); PFE at 95-97.5% confidence via Monte Carlo (simulate risk-factor paths, revalue the netting set at each time step, take the percentile of max(value, 0)); EE/EPE as the capital basis; EAD = 1.4 × (RC + PFE add-on) under SA-CCR; CVA = LGD × Σ EE_i × PD_i × DF_i. Aggregate across all desks, products, and legal entities facing the counterparty — a trade missing from the counterparty risk system is unmeasured exposure. Wire pre-deal limit checks into order flow, monitor post-trade for market-driven breaches, alert at ~80% utilization, and hard-block at 100%. Review cadence: annual full review for top-tier names, semi-annual for lower tiers, monthly (or more) for the watch list.

Workflow B: Responding to a Credit-Deterioration Event

Early-warning thresholds that should put a counterparty on the watch list before any downgrade: sustained CDS widening (e.g., 50bp over 30 days, or absolute spread above 300bp), stock price decline >30% over 60 days, negative rating outlook, covenant breaches, regulatory enforcement actions, accounting restatements, or significant client withdrawals.