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

6.3 Derivative Product Companies

6.3.1 Standard DPCs

Long before the global financial crisis of 2007 onwards, whilst no major derivatives dealer had failed, the bilaterally cleared dealer-dominated OTC market was perceived as being inherently more vulnerable to counterparty risk than the exchange-traded market. The derivatives product company (or corporation) evolved as a means for OTC derivatives markets to mitigate counterparty risk (e.g., see Kroszner, 1999). DPCs are generally Triple-A rated entities set up by one or more international banks. A DPC is typically a bankruptcy-remote subsidiary of a major dealer, which, unlike an SPV, is separately capitalised to obtain a Triple-A credit rating.⁶ The DPC structure provides external counterparties with a degree of protection against counterparty risk by protecting against the failure of the DPC parent. A DPC therefore provides some of the benefits of the exchange-based system while preserving the flexibility and decentralisation of the OTC market. Examples of some of the first DPCs include Merrill Lynch Derivative Products, Salomon Swapco, Morgan Stanley Derivative Products and Lehman Brothers Financial Products.

The ability of a sponsor to create their own “mini derivatives exchange” via a DPC was partially as a result of improvements in risk management models and the development of credit rating agencies. DPCs maintain a Triple-A rating by a combination of capital, collateral and activity restrictions. Each DPC has its own quantitative ...