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Counterparty risk in credit markets

Quantitative Credit Strategy 20 February 2008

Arup Ghosh Counterparty risk in CDS contracts has been a hot topic recently with a focus on losses
+44 (0)20 7773 6275 for protection buyers due to cross defaults of counterparties and reference entities. Using
[email protected]
a method with an explicit correlation figure measuring the likelihood of simultaneous
Graham Rennison defaults, we find that expected aggregate losses to protection buyers in such scenarios
+44 (0)20 7773 8544 are generally at the lower end of the scales discussed. However, although this may be the
[email protected]
most significant example of uncollateralised gap risk in the CDS market, we argue that
Arne Soulier this is a narrow definition of counterparty risk, with other possible concerns involving loss
+44 (0)20 7773 9996 of mark-to-market gains and gap risk in other OTC derivatives.
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This report is divided into the following sections:
Puneet Sharma
+44 (0)20 7773 9072
ƒ A detailed overview of credit derivative counterparty risk in all its forms and the
[email protected] extensive methods used by financial institutions to understand and mitigate
these exposures;
Magdalena Malinowska
+44 (0)20 7773 5626 ƒ An analysis of the effect of collateral policies that can significantly reduce losses in
[email protected] most scenarios but can leave gap risk (of any kind) as a concern;
www.barcap.com ƒ An examination of a hypothetical default scenario of a major financial institution,
with a discussion of knock-on effects across asset classes.
Additionally, we introduce a model that allows us to quantify expected losses due to
simultaneous defaults of reference and counterparty credits. This allows us to:
ƒ Estimate the theoretical cost of trading with different counterparties. For example,
with a BBB reference, current market levels would imply that buying 5yr protection
from an AA counterparty should cost an additional 6bp a year over the price from a
single-A counterparty. One year ago, this incremental cost would have been an
almost negligible 1bp;
ƒ Examine an extensive range of market scenarios and estimate aggregate losses to
protection buyers in each case. Our base scenario suggests a loss of $16bn across
the market (after accounting for collateralisation), but it is even more interesting to
analyse the range of these losses when they are stressed on the dimensions of
assumed default rates, correlation and recovery rates.

Counterparty risk in credit derivatives

Counterparty risk is the risk taken on by each party in an over-the-counter (OTC)
contract that the other will not fulfil the obligations of that contract. Typically this is a
risk concerning only OTC contracts as exchange-traded derivatives are guaranteed by
the exchange itself 1 . Counterparty risk is theoretically present in all asset classes; FX
derivatives, IR swaps, OTC equity derivatives and credit derivatives. In this note we
focus on the credit derivatives angle.

1It is worth mentioning, though, that even exchanges and clearing houses carry a slight risk of default and thus

theoretically have some counterparty risk.

Please read carefully the important disclosures at the end of this publication.
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As an illustration, Figure 1 shows the maximum potential loss to either party of a CDS
contract. While the maximum potential loss to the seller of protection is the contract
spread for the rest of the contract duration, the buyer of protection could arguably lose
the full notional of the contract (in case of simultaneous defaults by counterparty and
the reference credit and zero recovery). Thus, counterparty risk is evidently more of a
concern for buyers of protection.

Counterparty risk
Figure 1: Maximum potential loss to either party of a CDS contract
is highly skewed
towards the buyer of referencing a corporate credit (based on 25 January 2008 data)
CDS protection 120%
Seller of protection

100% Buyer of protection

80%

60%

40%

20%

0%
AAA AA+ AA AA- A+ A A- BBB+ BBB BBB- BB+ BB BB- B+ B
Reference rating
Source: Markit, Barclays Capital

At a basic level and assuming no collateral has been exchanged, in the event of a failure
of a counterparty the protection buyer may face one of the following scenarios:
ƒ The original contract is out-of-the-money, in which case the survivor closes out the
position with the defaulter by paying off its obligations and then re-hedges its
position with a new counterparty. There is no profit or loss incurred in this case by
the survivor due to the counterparty defaulting;
ƒ The original contract is in-the-money, in which case the survivor closes out the
position with the defaulter but does not receive its dues. The survivor in this case
incurs a loss equal to the market value of the old CDS contract.
Figure 2 illustrates a possible timeline around a typical counterparty default scenario,
highlighting the actual risks faced by the surviving counterparty.

Figure 2: Timeline around CDS counterparty default

Counterparty defaults Time

Last margin call Counterparty CDS position

position closed rehedged

t1 t2 t3 t4

Jump-to-default / spread gap risk

(net of margin collateral)
Source: Barclays Capital

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An extra risk arises because of the unhedged position of the survivor between time “t1”
(when it received the last margin payment) and “t4” (when it re-hedges its position).
The survivor remains exposed to the risk of spread on the reference gapping fast in this
period, and for a buyer of protection, this gap-risk can be as high as a jump-to-default.

Managing counterparty risk

Banks and other financial institutions that have large derivative exposures use several
techniques to limit, forecast and manage their counterparty risk. These techniques are
usually implemented at the firm level, across asset classes. The standard practises
implemented by banks can be roughly divided into the following three categories:
ƒ Contractual credit risk mitigation
ƒ Risk forecasting
ƒ Risk management

Contractual credit risk mitigation

All ISDA contract It is standard practice for financial institutions to enter derivative contracts
holders are ranked pari documented on Master Agreements as recommended by the International Swaps and
passu to senior debt, in Derivative Association (ISDA). All ISDA contract holders are ranked pari passu to senior
terms of claims on a debt, in terms of claims on a defaulting counterparty. This makes CDS contract holders’
defaulting counterparty positions sensitive to standard recovery rate assumptions. The Credit Support Annexes
(CSA) to the Master Agreement help parties establish bilateral mark-to-market security
arrangements. The following methods are typically adopted to help mitigate credit risk.
ƒ Margining and collateral posting. Margin agreements require banks to post
different levels of collateral on their outstanding contracts depending on the
current mark-to-market of the contract. Typical acceptable collateral is either cash
or highly-rated (AA or higher) securities. Margin thresholds are usually the
previous day’s mark-to-market for all outstanding contracts, but exceptions might
be made for highly-rated corporates.
Given their higher risk profile, margining for hedge funds tends to be somewhat
more stringent. They typically post collateral at 100% of their current exposure,
and furthermore might also be asked to post collateral to cover close-out risk on
their contracts for a certain number of days going forward. The estimation of
forward exposure is done through forecasting future scenarios, as explained in
further detail in the next section.
Hedge funds might be
asked by dealer/brokers Margining is perhaps the most effective way of reducing counterparty risk. It
to post margin to cover minimises gap risk to just within the period between margin calls.
closing-out risk
While margining mitigates to a large extent the mark-to-market risk of liquid
going forward
instruments, it must be mentioned here that it is only as effective as its operational
implementation. Various factors play a role such as:
` The frequency of margin calls;
` The time it takes for collateral posted to reach the bank (typically T+2 or T+3
but could be longer);
` The quality of collateral (whether cash or securities of doubtful quality);
` The difficulty in pricing complex illiquid instruments on a daily basis; and

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` Perhaps most significantly, the ability of small entities to impose two-way

margin agreements with bigger counterparties all affect the effectiveness of
margin agreements in practice.

Netting agreements are ƒ Netting agreements. Another advantage of trading within the ISDA framework is the
typically applicable provision of netting. Netting agreements come into action in the case of actual
across all derivatives counterparty default. Without such agreements, a surviving counterparty would legally
that are traded on have to fully meet its obligations to the defaulting counterparty, while only being left
ISDA contracts with a claim on its dues from the same. However, the provision for netting allows a
bank to calculate its dues to a defaulter by netting out-of-the-money and in-the-money
contracts and to arrive at a single figure for dues. In fact netting agreements are
typically applicable across all derivatives that are traded on ISDA contracts, effectively
building in a natural hedge to counterparty default risk on a firm-wide level.

Risk forecasting
A drawback of margining is that it is almost always backward looking, and thus leaves
the bank exposed to sudden changes going forward. To help mitigate this, there needs
to be some way of estimating future exposures to specific counterparties. The actual
estimation of Potential Future Exposure (PFE) that a bank has to its counterparties is a
very complex task. Most banks have sophisticated risk management systems which
model and attempt to quantify these exposures. This is usually done by simulating
future market scenarios on a Monte Carlo engine, using evolution models of all relevant
risk factors. In each scenario, at each point in time, pricing models value all outstanding
derivative contracts thus estimating the bank’s net counterparty risk exposure.
Repeated simulations on the Monte Carlo engine help provide a distribution of the risk
at different points of time in the future.

Active risk management

This forecasting of counterparty exposure allows banks to manage their risk going
forward by:
ƒ Placing limits on exposure to any given counterparty. The first step in managing
future exposure for a bank would be to limit exposure to the specific name. Limits
are typically monitored at both a firm-wide level and across asset classes;
ƒ Actively managing counterparty exposure. Having arrived at some estimate for
Hedging counterparty counterparty risk, a bank will often actively try to hedge that risk by netting
risk by buying further exposures across asset classes and then buying CDS protection on the specific
protection on the name counterparty to cover the risk. While this might sound circular and liable to add
works because more counterparty risk instead of reducing it, it works in practice because of the
of margining margining of such trades.
It is worth keeping in mind that buying CDS protection to manage risk is not
possible for hedge funds or smaller institutions. This is part of the reason such
entities have to pay close-out margin, covering potential future exposures.

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How much should I pay for a higher-rated

counterparty?
Estimating a bank’s net counterparty exposure is a very complex task, but much simpler
models can be used to estimate counterparty risk approximately. These models
typically use as inputs the risk priced into single-name CDS contracts by the credit
derivatives market.
All else being equal, a buyer of protection would prefer to trade with a higher-rated
counterparty as this would imply a lower risk of counterparty default. Though the
current CDS market does not currently discriminate between protection sellers with
different ratings, it is at least theoretically possible to price the risk inherent in buying
credit protection from a riskier counterparty. Further, if default rates were to see a
significant uptick in the future, these prices could be expected to begin to be factored
into actual market quotes.
As explained in the first section, in a CDS contract the buyer of credit protection has the
biggest value at risk (VaR), viz. notional x (1 - recovery) in the case of simultaneous
defaults of the counterparty and the reference credit. Estimating the market-implied
price of this VaR gives a very conservative estimate of counterparty risk.
Assuming survival of the buyer of protection over any period of time, we can get the
following 4 “default scenarios” for the reference and the seller of protection:

Figure 3: Default scenarios for counterparty and reference credit

Reference defaults
Counterparty does not default
I
Reference credit defaults
time No loss to buyer of protection

Counterparty defaults
Counterparty defaults
II Reference credit does not default
Likelihood of small loss to buyer of protection
time
Reference defaults Counterparty defaults
Counterparty defaults after reference credit defaults
III No loss to buyer of protection
time

Counterparty defaults Reference defaults

Counterparty defaults before reference credit defaults
IV Likelihood of significant loss to buyer of protection

time

Source: Barclays Capital

This section models the likelihood of the fourth scenario illustrated above. In our
analysis, we ignore the effects of the protection buyer re-hedging his position
immediately after the counterparty defaults. This implies an assumption that all double
defaults within any given time horizon happen concurrently. While this might not be
very realistic it provides a more conservative estimate of counterparty risk.
The CDS curve for any entity implies a default probability function for that entity. To
determine the counterparty risk we join these CDS implied marginal default
probabilities of the counterparty and the reference into a bivariate distribution, using a
Gaussian copula model 2 . This allows an estimation of the joint default probability of the
counterparty and the reference. This joint default probability is converted back into a

2 On Default Correlation: A Copula Function Approach, by David X. Li

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spread using expected loss measures. Running the above model on different dates
allows us to gauge the evolution of counterparty risk as priced in by the credit market.
We prefer to use market implied probabilities of default as opposed to historically
realised default rates, since the former provide a more dynamic and forward-looking
estimation of risk.

Figure 4: Modelling the spread price of counterparty risk

a) Cash flows in a CDS contract b) Setting a price to counterparty risk

spread implied pro bability o f default fo r

Buyer of 112 bps Seller of protection (B) co unterparty bank (65 bps) = 5.7%
protection AA- rated bank
(A) 5 year spread = 65bps biv a ria t e ga us s ia n
c o pula m o de l
1 - Recovery

Notional =1
default pro bability
Recovery co rrelatio n implied spread
= 0.2 fo r
co unterparty
Reference credit (C) risk
= 2.75 bps
BBB+ corporate
5 year spread = 112bps

Default cash flows

assumed reco very rates
spread implied pro bability o f default fo r = 40% fo r bo th reference
Non-default cash flows
reference credit (112 bps) = 9.9% and co unterparty

Source: Markit, Barclays Capital

We make several simplifying assumptions in the implementation of this model, some of

which cause an overestimation of the actual risk due to counterparty default. These are:
ƒ Ignoring the impact of margining and netting in reducing risk. This impact can be
quite significant, for instance, in the case of a gradual deterioration of the reference
credit, mark-to-market gains ought to be gradually collateralised, reducing the size
of the jump-to-default loss;
ƒ No re-hedging if counterparty defaults before the reference, in effect assuming
instantaneous default whenever defaults are correlated.
Other significant assumptions we make are as follows:
ƒ The ordering of default is assumed to follow a symmetrical distribution, ie, the
likelihood of the reference credit defaulting before the counterparty is taken to be
the same as that of the counterparty defaulting before the reference credit;
ƒ A recovery rate of 40% is assumed for the counterparty and 10% for the reference;
ƒ The correlation of asset returns between financial entities and corporates is
assumed to be 80%.

A buyer of protection The rationale behind using asset correlation of financials and corporates as an input
would prefer to trade into the model is that, when such correlation is high, it will indicate an increased
with a counterparty with probability of joint default. In our model the worst-case scenario is a 100% correlation
least business risk of returns, when double defaults will be most likely. Intuitively, this means a buyer of
(correlation) tied in with protection would always prefer to trade with a counterparty with least business risk tied
the reference credit in with the reference credit.

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Using the above described model with banks as counterparty and corporates as
reference credits, we get the following spread numbers on a rating by rating basis.

Figure 5: Average spread price of counterparty risk on 5yr CDS; 25 January 2008
25 Jan 08 Corporate reference credit
ρ = 0.8 Rating AAA AA+ AA AA- A+ A A- BBB+ BBB BBB- BB+ BB BB- B+
Rating Avg spread (bp) 33 37 48 52 62 58 78 73 120 147 233 320 362 526
AA 68 9 10 12 13 14 14 16 16 20 22 25 26 27 27
AA- 74 10 11 13 14 15 15 17 17 22 24 27 29 30 31
A+ 83 11 12 15 16 18 17 20 20 26 28 34 36 37 39
Counterparty
bank A 86 11 12 15 16 18 17 20 20 26 29 34 37 38 40
(protection A- 284 15 17 21 23 27 26 33 32 49 57 80 97 103 120
Seller)
Source: Markit, S&P, Barclays Capital

The interpretation of the above numbers is that these are the annual spread that a
buyer of protection should price in due to counterparty default. For example, the
number in the first cell shows that CDS protection bought from a AA rated
counterparty referencing a AAA rated corporate, carries a counterparty risk (over five
years) equivalent on average to the default risk of an entity with 9bp (5yr maturity)
CDS spread.
It is also interesting to note the differential in spreads across rows, viz. across banks of
different ratings. To take another example, Figure 5 indicates that the price of
counterparty risk in a 5yr CDS contract on a AAA reference bought from a AA bank is
on average 9bp. However, the same protection bought from an A- bank has a
counterparty risk of 15bp. Thus, the A- rated bank should have a 6bp lower ask as
compared to the AA rated bank, given its greater risk of defaulting.
Figure 6 shows the same calculations, but based on spread-implied default rates at the
beginning of 2007. Not surprisingly, we find the levels are much lower than they are
today – in the extreme cases by a massive factor. For example, the estimated
compensation for counterparty risk with a A- counterparty and a B+ reference has
increased 17 times over the last year.

Figure 6: Average spread price of counterparty risk on 5yr CDS; 25 January 2007
25 Jan 07 Corporate reference credit
ρ = 0.8 Rating AAA AA+ AA AA- A+ A A- BBB+ BBB BBB- BB+ BB BB- B+
Rating Avg spread (bp) 4 5 6 11 11 15 19 27 29 47 64 119 141 173
AA 6 1 1 1 1 1 1 2 2 2 2 2 3 3 3
AA- 6 1 1 1 1 1 2 2 2 2 2 3 3 3 3
A+ 8 1 1 1 2 2 2 2 2 2 3 3 4 4 4
Counterparty
Bank A 10 1 1 1 2 2 2 2 3 3 4 4 4 4 5
(protection A- 16 1 1 2 2 2 3 3 4 4 5 6 7 7 7
seller)
Source: Markit, S&P, Barclays Capital

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Estimating risk in the system

Expected losses due to correlated defaults
Since they were introduced, credit derivatives have become increasingly popular with
banks and investors as a way of managing risk. This, combined with their attractiveness
as a clean way to express directional credit views, has led to exponential growth in their
use. The OTC nature of credit derivative contracts, however, makes it difficult to
estimate accurately the total size of the market. Further, as counterparty risk arises only
in the case of privately-settled contracts between two entities, it is in effect private
information. This further compounds the difficulties of making any kind of estimate of
the level of risk the financial industry faces as a whole due to counterparty defaults.
Using the methodology outlined in the previous section as well as overall market
statistics released by the Bank for International Settlements, we try to approximate the
total risk inherent in the system. We do this by estimating on an aggregate basis the
expected losses to surviving entities when counterparties and reference credits both
default. Of course the assumptions highlighted previously introduce a high degree of
uncertainty into the estimated loss number. Our analysis aims to provide a
methodology for approaching the problem, and the figures are meant to be ball-park,
not exact estimations of risk in the market.
The BIS releases bi-annual figures summarising estimates of OTC derivatives market
statistics polled from broker/dealers in 47 jurisdictions including the G10 and
Switzerland. These figures allow some estimation of the total size of the credit
derivatives market, as indicated in Figure 7.

Figure 7: Bank for International Settlements figures for outstanding CDS (June 2007)
Notional amounts outstanding of reporting dealers ($trn) Counterparty break-up of protection sellers (June 2007)
45 1%
10%
40 1%

35
11%
30

25

20

15

10
Reporting dealers
Banks and security firms 77%
5
Insurance and financial guaranty firms
0 Other financial institutions (incl. hedge funds)
Dec 04 Jun 05 Dec 05 Jun 06 Dec 06 Jun 07 Non-financial institutions
Source: BIS, Barclays Capital

Similar segmentation of the market is also available for the ratings of all reference
credits on which there are outstanding CDS contracts. Assuming homogeneity between
the distributions of counterparty and those of the reference, we can arrive at the
following segmentation of the entire CDS market, as shown in Figure 8.

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Figure 8: CDS market segmentation on the basis of outstanding notionals

As of June 2007 Reference credit rating
IG HY NR

Type of Banks/Insurance 57.7% 12.0% 19.5%

counterparty Other financials 6.3% 1.3% 2.1%
(protection seller) Corporates 0.7% 0.1% 0.2%
Total 100%
Source: BIS, Barclays Capital

Given the average default probabilities for different segments, and assumed correlation
figures we can calculate approximate values of the expected loss in each segment. For the
type of counterparty categorised as “Other financials” we assume a very conservative
average rating of B-, to reflect the inclusion of hedge funds in that segment.
We must highlight here that all statistics reported by the BIS are from dealers/brokers,
and thus the total loss estimation only includes those deals that have dealer/brokers
as counterparty.

Figure 9: Expected loss due to counterparty default over the next year
Expected loss in market segment Expected loss in
25 Jan 08 (% of total notionals outstanding) market segment ($bn)
ρ = 0.8 Reference credit rating Reference credit rating
IG HY NR IG HY NR
Type of Banks/Insurance 0.056% 0.028% 0.045% 23.8 11.8 19.2
counterparty
Other financials 0.014% 0.016% 0.026% 5.9 6.8 11.2
(protection
seller) Corporates 0.001% 0.001% 0.001% 0.4 0.2 0.4
Total 0.172% 80
Note: Assumes flat correlation of 80% between counterparty and reference entity default events. Source: BIS, Markit, Barclays Capital

The first three columns give the expected loss over one year as a percentage of notional
for a counterparty and reference credit of the indicated types. This expected loss is
calculated using the methodology described in the previous section. The total expected
loss in $bn for a segment is arrived at by multiplying this loss figure by the total
notionals outstanding for that segment.
The highlighted total of $80bn over the next year assumes 40% recovery for
counterparties, 10% recovery for reference, and an asset returns correlation of 0.8.

Stress testing these results

While the base-case scenario of $80bn of losses provides an initial reference point to
estimate counterparty risk on a systemic basis, we reckon there is even more information to
be gained from observing how changes in the different assumptions affect this overall
number. We present here a comprehensive set of stress-testing results on expected loss
outcomes, obtained at different estimates of the input parameters.

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The charts in Figure 10 summarise the sensitivity of the above base-case scenario to
changes in the following parameters:

ƒ Correlation. The correlation figure refers to the implied correlation of asset returns
of financials with corporates (counterparty and reference). Figure 10a estimates
the sensitivity of the total market loss to this assumption. The worst-case scenario
is when financials-corporate returns are 100% correlated making a double default
very likely. In this case, the total estimated loss to the market is about $108bn. A
negative correlation of asset returns obviously reduces the estimated loss further,
however, we do not think that this scenario is very realistic;
ƒ Time horizon. As the likelihood of default of any entity increases with an increased time
horizon, the total loss estimate to the system also increases. However, it is unrealistic to
expect asset returns to remain as highly correlated as 80% over long periods of time.
We thus modify our base-case scenarios by reducing the implied correlation
assumption to 60% over two years and even further down to 40% over three years;
ƒ Recovery rates. The effect of counterparty and reference recovery rates is theoretically
symmetrical on the total system loss. Figure 10c summarises these effects;
ƒ Default rates. Our calculations use market spread implied default probabilities. We
stress-test these assumptions by calculating the loss to the system at different
multiples of the current implied default probabilities for both the counterparty and
the reference entity. This accounts for deviations in future realised default rates
from current spread implied rates.
In each of the charts below, the base case itself is highlighted with the dashed circle.

Figure 10: Sensitivity of market loss ($bn) to different parameters

a) Sensitivity to correlation of asset returns b) Sensitivity to time horizon and correlation of asset returns
140 500 1 year
450 2 years
120 3 years
400
100 350
80 300
$ 80 bn
250
60
200
$ 182 bn
40 150
$ 135 bn
100
20
50 $ 80 bn
0 0
-0.2 0.0 0.2 0.4 0.6 0.8 1.0 -0.2 0.0 0.2 0.4 0.6 0.8 1.0
Asset returns correlation Asset returns correlation
c) Sensitivity to counterparty and reference recovery rates d) Sensitivity to default probabilities
160 Counterparty RR = 0% 300 Counterparty Pd = x0.5
Counterparty RR = 25% Counterparty Pd = x1.0
140 Counterparty RR = 50% Counterparty Pd = x1.5
250 Counterparty Pd = x2.0
Counterparty RR = 75% Counterparty Pd = x2.5
120 Counterparty RR = 100% Counterparty Pd = x3.0
200
100
80 150
60 $ 80 bn
100
40
50 $ 80 bn
20
0 0
0% 20% 40% 60% 80% 100% x0.5 x1.0 x1.5 x2.0 x2.5 x3.0
Reference RR Reference Pd

Source: BIS, Markit, Barclays Capital

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Accounting for collateralisation

The biggest drawback of the analysis in the previous section is that it ignores all risk-
management techniques used by banks, the most significant of which are the use of
collateral and netting.
It is very difficult to gauge the degree to which netting will aid a bank if a counterparty
defaults; that will depend on specific exposures across asset classes that the specific
bank has to the specific counterparty.
However, it is easier to estimate the effect of collateralisation. ISDA’s Counterparty Risk
Concentration Survey (May 2007) highlights the following effects of collateralisation on
the net market exposure of dealer/brokers:

Figure 11: Mean exposures before and after collateral as % of total exposure
Reduction of exposure
Before collateral After collateral due to collateralisation
Ten largest 9.87% 2.00% 80% = (1 - 2%/9.87%)
dealers
Non-dealer 11.13% 6.25% 44% = (1 - 6.25%/11.13%)
counterparties
Hedge funds The ISDA survey does not provide any figures on collateralised versus uncollateralised
exposure for dealer/brokers to hedge funds because, as they report, “all hedge fund exposures
are more than fully collateralised with independent amounts posted upfront and variation
margin posted subsequently as exposure changes”.
We thus make the conservative assumption that dealer/brokers face the same degree of risk
from a hedge fund defaulting, as from another dealer/broker.
Source: ISDA, Barclays Capital

Reducing the expected losses in Figure 9 by the proportions highlighted above, we

arrive at a new base-case scenario for counterparty defaults, as indicated below.

Figure 12: Expected loss due to counterparty default over the next year after accounting
for collateralisation
25 Jan 08 Expected loss in market segment Expected loss in market segment ($bn)
(% of total notionals outstanding)
ρ = 0.8 Reference credit rating Reference credit rating
IG HY NR IG HY NR
Type of Banks/Insurance 0.011% 0.006% 0.009% 4.8 2.4 3.9
counterparty
Other financials 0.003% 0.003% 0.005% 1.2 1.4 2.3
(protection
seller) Corporates 0.001% 0.000% 0.000% 0.2 0.1 0.2
Total 0.036% 16
Note: Assumes flat correlation of 80% between counterparty and reference entity asset returns Source: BIS, ISDA, Markit, Barclays Capital

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The new base-case scenario (with same assumptions of correlation and recovery rates)
indicates about one-fifth the amount of losses than before accounting for collateralisation.
The sensitivities to different parameters are also recalculated as follows:

Figure 13: Sensitivity of market loss ($bn) to different parameters

a) Sensitivity to correlation of asset returns b) Sensitivity to time horizon and correlation of asset returns

30 120 1 year
2 years
25 100 3 years

20 80
$ 16 bn
15 60

10 40 $ 37 bn

5 $ 28 bn
20
$ 16 bn
0 0
-0.2 0.0 0.2 0.4 0.6 0.8 1.0 -0.2 0.0 0.2 0.4 0.6 0.8 1.0
Asset returns correlation Asset returns correlation
c) Sensitivity to counterparty and reference recovery rates d) Sensitivity to default probabilities

35 Counterparty RR = 0% 60 Counterparty Pd = x0.5

Counterparty RR = 25% Counterparty Pd = x1.0
30 Counterparty RR = 50% Counterparty Pd = x1.5
Counterparty RR = 75% 50 Counterparty Pd = x2.0
Counterparty RR = 100% Counterparty Pd = x2.5
25 Counterparty Pd = x3.0
40
20
30
15
$ 16 bn
10 20
$ 16 bn
5 10

0 0
0% 20% 40% 60% 80% 100% = x0.5 = x1.0 = x1.5 = x2.0 = x2.5 = x3.0
Reference RR Reference Pd
Source: BIS, ISDA, Markit, Barclays Capital

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What happens if… ?

Scenarios in case of an actual counterparty default
The previous section investigates the total risk to the financial system from potential
correlated defaults in the next year. However, it is also of interest to determine what
happens when an actual counterparty does default. The default of a major bank/broker
would obviously affect the whole market, and the impact would not just be limited to
credit derivative contracts but also other OTC contracts (some of which exist in far
higher notionals that CDS contracts).
In this section we therefore assess the damage to the financial system from a failure of a
major counterparty, say from large unexpected losses, writedowns and the failure to raise
adequate capital. While we do believe that it is rather unlikely and hence consider it a tail
event risk scenario, it is nevertheless useful to assess what happens in such a situation.
Even in the absence of reference entity default, a failure of a major counterparty could
lead to losses across the financial system. Upon the default of the counterparty, OTC
derivatives would be immediately and significantly re-priced, with credit spreads likely
widening dramatically. This means that CDS contracts would be terminated at a spread
significantly higher than the spread at which collateral was last posted, leading to the
crystallisation of significant losses.

The mechanics of gap risk loss on CDS positions

In this section we focus on losses which are crystallised due to a default-induced re-pricing
of credit in the period between the last posting of collateral and contract termination.
We assume the following scenario, which is illustrated in Figure 14. Throughout the period
before T1, a major counterparty buys and sells protection with a host of investors. These
positions are fully margined and collateralised on a daily basis. This implies that all daily
MTM P&L is locked in and immune from risk from counterparty default. It also implies that
all investors – in the money and out of the money protection buyers and sellers – are
exposed to the same gap risk from counterparty defaulting. This is the risk of spreads
jumping significantly from levels at which the posting of collateral takes place and levels at
which the contract is terminated. If a major counterparty defaults, we believe credit spreads
are likely to re-price significantly and immediately.
In this scenario, both protection buyers and protection sellers face losses.
ƒ Protection sellers realise the full loss of negative MTM resulting from the jump in
spreads. As spreads gap wider, protection sellers incur a MTM loss, which they have
to honour and pay to the defaulted counterparty as the contract is terminated.
ƒ Protection buyers realise the loss equal to the foregone MTM profit from the jump
in spreads, less the recovery of this profit from the defaulted counterparty. As
spreads gap wider, protection sellers make a MTM gain, which, they do not receive
from the defaulted counterparty. They make a claim on this MTM profit on the
defaulted counterparty and they receive certain recovery value on this in due
course.

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Figure 14: Gap risk due to jump in spreads of reference credit between
last posting of collateral and contract termination
110
all the MTM P&L until this counterparty
100 point is locked in due to full defaults
gap risk:
collateralisation spreads jump
90

spread (bp)
sharply between
80 the last margin

70 call and contract

termination
60

50

40
T0: T1: T2:
time (t)
contract last posting of termiantion of
initiation collateral the contract
Source: Barclays Capital

Illustrating potential gap risk losses on CDS positions

The total notional amount outstanding of OTC credit derivatives for broker/dealers is
$42.5trn 3 . There are approximately 55 broker/dealers who buy or sell protection. In
this exercise we analyse a scenario where a relatively large counterparty defaults. We
assume that this counterparty sold $1trn of protection and bought $1trn of protection.
We further assume that the proportion of IG protection sold by the counterparty is 65%
(please refer to Figure 8) and the average life of contract affected is five years. We
continue to assume that the recovery rate on the counterparty is 40%.
We believe that a default of a major counterparty would cause a significant re-pricing in
credit. Although consequences of such an unprecedented event are difficult to quantify, we
estimate losses for a variety of scenarios. In our analysis, we allow the IG credit spreads to
jump between 10bp and 60bp upon a counterparty default. We view the IG spread jumps of
30-40bp as the most likely in case of a default of a counterparty with $2trn of outstanding
CDS. Assuming a beta of 4x between the Crossover and the Main, we imply that HY spreads
could jump between 40bp and 240bp, with 120-160bp being most likely.

Figure 15: Scenario assumptions

Assumptions:
Total protection bought and sold by the defaulting counterparty: $2trn
Proportion IG: 65%
Average life of contract affected: 5 yr
Recovery rate for the counterparty: 40%
Potential IG spread jump on a counterparty default: Minimum: 10bp
Maximum: 60bp
Beta of HY versus IG: 4x
Source: Barclays Capital

Our analysis shows that the failure of a major counterparty which had $2trn outstanding in
OTC credit derivatives, could result in losses of $36-47bn in the financial system solely due
to the immediate re-pricing of credit risk due to a counterparty default. We stress that

3 Bank of International Settlements data

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these losses are crystallised by investors who had exposure to the defaulting counterparty.
Additional to these, there would also be large, potentially concentrated, MTM losses for
investors without exposure to the defaulting counterparty. These losses would result from a
re-pricing of risk, which we do not account for here.

Figure 16: Potential credit losses from gap risk upon a default of a
major counterparty
80
most likely scenario
total gap risk loss on counterparty 70 in our view
71
60
59
50
default ($bn)

47
40

30 36

20 24

10
12
0
10 20 30 40 50 60
jump in IG spread (bp)

Source: Barclays Capital

However, we would add the caveat that netting could significantly reduce our estimated
losses. The figures above are un-netted, as data on netted exposures is very hard to obtain.
There are two factors which could cause the realised losses to be larger than our
estimates. The first is the fact that, while we assumed full collateralisation, in reality,
collateralisation is imperfect. This would mean that at the point of last posting of
collateral, there would be some MTM positions which are not backed by collateral and
any losses on these positions would increase the loss from gap risk. The second is
forward margining. Any collateral posted by hedge funds with the defaulting
counterparty as part of forward margining would be subject to a loss. This loss would
amount to the value of collateral less recovery.

Other derivative contracts could be significantly affected

Thus far in our analysis we have concentrated solely on credit derivatives. However, in terms
of amounts outstanding, credit derivatives constitute only 8% of all the OTC derivatives,
with interest rate derivatives constituting the largest proportion of 67% (Figure 17). We
believe that a default of a major counterparty would cause a significant re-pricing in all OTC
derivatives. This implies that these contracts would also be vulnerable to large gap risk.
Given the enormous amounts outstanding of these derivatives, netted exposures could be
large and therefore gap risk losses on other OTC derivatives could be significant.

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Figure 17: OTC derivatives by amounts outstanding

400
347

Notional amount outstanding ($trn)

350

300

250

200

150

100 62
49 43
50
9 8
0
Interest rate Other Foreign Credit default Equity-linked Commodity
contracts exchange swaps contracts contracts
contracts

Source: Bank of International Settlements

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Quantitative Credit Strategy Research Analysts

Barclays Capital
5 The North Colonnade
London E14 4BB

Graham Rennison Ulf Erlandsson Arup Ghosh

+44 (0)20 7773 8544 +44 (0)20 7773 8363 +44 (0)20 7773 6275
[email protected] [email protected] [email protected]

Matthew Leeming Xavier Angeli

+44 (0)20 7773 9320 +44 (0)20 777 31098
[email protected] [email protected]

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