/counterparty-risk

name: counterparty-risk
description: "Guide counterparty credit risk measurement and management for OTC and securities trading, organized around three workflows: assessing a new counterparty, responding to a credit-deterioration event, and executing a default close-out. Use when measuring current or potential future exposure to a counterparty, setting or reviewing counterparty credit limits, evaluating ISDA Master Agreement netting and close-out mechanics, designing CSA collateral terms or uncleared margin compliance (VM/IM, SIMM), assessing central clearing mandates under Dodd-Frank or EMIR and CCP default waterfalls, monitoring creditworthiness via CDS spreads or ratings, quantifying wrong-way risk, or computing EAD, SA-CCR, and CVA. For Reg T and FINRA Rule 4210 brokerage margin see margin-operations; for settlement risk, DVP, and CLS see settlement-clearing."

Counterparty Risk

Core Concepts

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.

1. **Confirm and classify the trigger.** Initiate a formal credit review: temporary setback (a bad quarter, a one-time loss) or structural deterioration (capital erosion, rising NPLs, franchise decline)? Review the latest financials, disclosures, and analyst coverage. 2. **Enforce CSA downgrade provisions.** Check for ratings-linked threshold step-downs and additional termination events; call any collateral the CSA now permits (a threshold stepping to zero converts the prior threshold amount into an immediate collateral call). 3. **Reduce the credit limit.** Convene the credit committee and re-tier the counterparty. If current exposure now exceeds the reduced limit, document the breach and a dated remediation plan. 4. **Reduce exposure.** In rough order of cost: let maturing trades roll off without replacement; execute offsetting trades; novate trades to other counterparties (requires consent); unwind by agreement with a close-out payment. Prioritize long-dated, high-PFE trades for novation or unwind; short-dated trades maturing within weeks rarely justify early-terminat