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Counterparty Credit Risk: The new challenge for global financial markets by Jon Gregory

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13

Counterparty Risk of Default-remote Entities

“The fact that a great many people believe something is no guarantee of its truth.”

W. Somerset Maugham (1874–1965), The Razor’s Edge, 1943

In this chapter we review the role of default-remote or triple-A type entities, a general concept that over the years has seen many forms. This area has proved to be the Achilles heal of financial markets with respect to counterparty risk. Triple-A ratings have been assigned to corporates or legal entities based on flawed logic in relation to aspects such as the underlying business model or legal structure. Furthermore, the behaviour of market participants in relation to the “too big to fail” institutions further accentuates the illusion that there is little or no underlying counterparty risk. As discussed already, the failure of institutions such as AIG, Fannie Mae, Freddie Mac and monoline insurers has forever shattered the “too big to fail” illusion. In this chapter we will review historically the role of the triple-A counterparty and assess the strengths and weaknesses of the default-remote entity with respect to counterparty risk. We look at the role of derivatives product companies, monoline insurers and credit derivatives product companies within the financial markets. The discussion will form the basis for some of the arguments in the next and final chapter examining the concept of central counterparties.

13.1 THE TRIPLE-A COUNTERPARTY

In the early days of the derivatives markets, there ...

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