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

6.4 Monolines and Credit DPCs

6.4.1 Rationale

As described above, the creation of DPCs was largely driven by the need for high-quality counterparties when trading OTC derivatives. However, this need was taken to another level with the birth and exponential growth of the credit derivatives market from around 1998 onwards.

The first credit derivative product was the single-name credit default swap (CDS). The CDS represents an unusual challenge since its value is driven by credit spread changes whilst its payoff is linked solely to one or more credit events. This so-called wrong-way risk (see Chapter 15 for more detail) meant that the credit quality of the CDS counterparty became even more important than it would be for other OTC derivatives. Beyond single-name credit default swaps, senior tranches of structured finance CDOs had even more wrong-way risk and created an even stronger need for a “default-remote entity”. Put simply, the credit derivatives market needed Triple-A protection sellers and, given its rapid growth, it needed them fast.

6.4.2 Monoline Insurers

Monoline insurance companies (and similar companies such as AIG⁸) are financial guarantee companies with Triple-A ratings that they utilise to provide credit wraps which are financial guarantees. Monolines began providing credit wraps for US municipal finance but then entered the single-name CDS and structured finance arena in a big way to achieve diversification and better returns. In order to justify their ratings, monolines ...