Counterparty Credit Risk: The new challenge for global financial markets

Chapter 3

Mitigating Counterparty Credit Risk

“One ought never to turn one’s back on a threatened danger and try to run away from it. If you do that, you will double the danger. But if you meet it promptly and without flinching, you will reduce the danger by half.”

Sir Winston Churchill (1874–1965)

3.1 INTRODUCTION

In this chapter, we discuss ways of mitigating counterparty credit risk. The methods for doing this predominantly focus on reducing current credit exposure and potential future exposure. They often do not change the probability of suffering a loss but do reduce the resulting exposure (for example, by increasing the amount that would be recovered in the event of default). The main methods discussed will be:

• Default-remote entities. Whilst this has become a rather laughable concept in recent years, the most simple and commonly used method of mitigating counterparty risk has always been to trade with an institution or vehicle with an underlying default probability that is very small. The “too big to fail” mentality discussed in Chapter 1 has somewhat fuelled this practice and led to clear problems which will be discussed in later chapters.
• Termination events. This represents the opportunity to terminate a transaction at some point(s) between inception and the maturity date. It may exist as an option or be conditional on certain conditions being met (ratings downgrade, for example).
• Netting. This refers to the ability to offset all transactions (both in an institution’s ...