Banks' new tool to deal with counterparty risk

Players in the $500,000bn market for over the counter derivatives have a lot to lose if their trading partners fail to pay what they owe.

Growing fears that problems among some counterparties – particularly those that do not post collateral – could wipe out trades across the market are prompting banks to develop a new weapon in the fight against counterparty risk.

The instrument, itself an exotic derivative, allows risk managers to hedge their exposure to any participant in the derivatives market.

Rudimentary and idiosyncratic versions of these so-called contingent credit default swaps (CCDS) have existed for five years, but they have been rarely traded due to high costs, low liquidity and limited scope.

But now there are high hopes that a revamped version of CCDS, which will bear the formal blessing of the International Swaps and Derivatives Association, will be more successful when it is released in two to three months' time.

Counterparty risk has become a particular concern in the markets for interest rate, currency, and commodity swaps – because these trades are not always backed by collateral, leaving banks vulnerable to sudden losses if counterparties collapse.

Many of these institutions – such as hedge funds and companies that do not issue debt – are beyond the scope of cheaper and more liquid hedging tools such as normal credit default swaps.

The new CCDS was developed to target these institutions. Some banks have already started doing deals using a rough and ready version of the forthcoming standardised documentation.

Trading volumes are thought to remain relatively small but, according to Bill Mertens, head of CCDS at Icap, the interdealer broker, demand has started to grow.

"We're constantly looking for the [point where growth] explodes. That may happen shortly," he says.

Unlike in a normal credit default swap, where the notional risk that is hedged is defined at the outset of the contract, each CCDS is linked to a second derivative, so the risk being hedged varies over time according to market movements in the underlying transaction. That means these contracts can be used to protect or lock in mark-to-market gains on the values of derivative contracts, as well as to protect dealers against counterparty risk.

But dealers are sceptical that the instrument will take off, particularly where more liquid, if imperfect hedges are available, for example through more traditional CDS. GFI, a rival interdealer broker to Icap, abandoned CCDS last year because of a lack of interest, though it said it would re-enter the market if demand picked up.

One counterparty risk officer at a leading European bank called CCDS "a product with nowhere to go".

He added that "CCDS would be a very useful product for banks that cannot disaggregate and hedge the separate risk components themselves".

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