Counterparty Credit Risk and Credit Value Adjustment: A Continuing Challenge for Global Financial Markets, 2nd Edition

6.1 Introduction

In the early days of the derivatives market, there was a tendency to deal only with the most creditworthy counterparties. Weaker credit quality counterparties were either excluded entirely or required to pay substantial premiums in order to trade. For many corporates and sovereigns, this would correspond to trading only with the most financially sound banks and broker dealers. Large dealers within the derivatives market needed strong credit ratings for this reason and set up Triple-A rated bankruptcy-remote subsidiaries – known as DPCs – to handle their derivatives dealing operations.

Obviously, the bankruptcy of Lehman Brothers and bailouts of other large banks have clearly had a very negative impact on the perceived long-term credit quality of banks globally. In addition, the trustworthiness of credit ratings has been severely reduced. For example, Lehman Brothers had a reasonably good “Single-A” rating at the time of its bankruptcy¹ and Icelandic banks had the best quality “Triple-A” ratings just weeks prior to their complete collapse.

6.1.1 Default Remoteness and Too Big to Fail

A “default remote entity” is a general concept that can be applied to several different ideas that have been or are important for the management of counterparty risk. The general idea of a default remote entity is that it provides a counterparty of such good credit quality that the default probability and thus the counterparty risk are essentially negligible. In the days when credit ...