2.5 Counterparty Risk in Context

2.5.1 The Rise of Counterparty Risk

Counterparty risk is traditionally thought of as credit risk between OTC derivatives counterparties. Since the global financial crisis, the importance of OTC derivatives in defining crises has made counterparty risk the key financial risk. Historically, many financial institutions limited their counterparty risk by trading only with the most sound counterparties. The size and scale of counterparty risk has always been important but has for many years been obscured by the myth of the creditworthiness of the “too big to fail” institutions such as those mentioned in Chapter 1. For many years, institutions ignored counterparty risk with high-quality (e.g., Triple-A) rated institutions, sovereigns, supranational or collateral posting entities. However, the financial crisis showed that these are often the entities that represent the most counterparty risk. The need to consider counterparty risk in all counterparty relationships and the decline in credit quality generally has caused a meteoric rise in interest in and around counterparty risk. Regulatory pressure has continued to fuel this interest. Whereas in the past, only a few large dealers invested heavily in assessed counterparty risk, it has rapidly become the problem of all financial institutions, big or small.

2.5.2 Counterparty Risk and CVA

Counterparty risk represents a combination of market risk, which defines the exposure, and credit risk, which defines the ...

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