Principles for Management of Credit Risk on Government Swaps

Counterparty credit standing (rating) : To limit the credit risk on swap counterparties, swaps are only transacted with counterparties with a very high credit standing. A counterparty must normally be rated minimum Aa3/AA- by at least two well-reputed rating agencies (Moody's, Standard & Poor's or Fitch). If a counterparty is rated by three rating agencies, the minimum requirement is based on the lowest rating. For interest-rate swaps in kroner and DKK/EUR swaps, however, counterparties with a rating of minimum A3/A- are permitted.

Limits for credit exposure (lines) : To avoid disproportionately high credit exposures, the credit exposure on a counterparty must be within an authorised line. The size of the lines granted depends on the counterparty's rating and net worth, cf. Table 1.

Compilation of counterparty credit exposure : Counterparties' credit exposure and utilisation of lines are monitored on an ongoing basis. The central government's credit exposure to a given counterparty is compiled as the current positive market value of the portfolio less any pledged collateral, plus a premium, the potential credit exposure, that takes into account that the portfolio can develop additional market value as a consequence of market development.

Handling of excess credit exposure : New swaps may only be transacted with a counterparty for as long as the credit exposure is less than 75 per cent of the authorised line. The remaining 25 per cent of the line is a buffer to limit the extent of excess credit exposure. In the event of excess credit exposure, the counterparty relationship is monitored closely. If the excess exposure is considered to be unacceptably high, it is sought to reduce the credit exposure.

Eligible swaps: Only plain-vanilla interest-rate swaps and plain-vanilla currency swaps may be transacted. The maturity will normally be 10 years or lower. Dual-currency swaps and zero-coupon swaps are considered to be plain-vanilla swaps. Structured swaps are no longer transacted. The same applies to deals that include option elements, including swaptions, interest-rate caps, etc.

Legal basis of agreement : Swaps are only transacted with counterparties with whom an ISDA Master Agreement, which governs the business relationship between the central government and the counterparty, and a collateral agreement, cf. below, have been established.

Netting : ISDA Master Agreements contain netting provisions whereby gains and losses on transacted swaps are set off in the event of counterparty default.

Master Agreements are signed only with counterparties domiciled in countries whose legislation is expected to provide for netting.

Early termination of swaps : It must be possible to terminate all swaps with a counterparty should the counterparty's rating fall to an unsatisfactory level. All new ISDA Master Agreements therefore contain rating triggers. A rating trigger entails that swaps can be cancelled should a counterparty's rating fall to a given level. In most of the central government's ISDA Master Agreements the rating trigger is BBB+/Baa1 or below^[1].

As a subsequent safeguard against credit losses, cross-default clauses are also applied. These allow swaps to be terminated if the counterparty defaults on its payment obligations to a third party.

Collateralisation : To limit any losses in the event of counterparty default, swaps may only be transacted with counterparties that have signed collateral agreements (ISDA Credit Support Annex) to the ISDA Master Agreements that regulate the relationship between the central government and the swap counterparties. The key elements of the agreements are:

The agreements are unilateral, so that only the central government's counterparties pledge collateral.

Collateral is not pledged unless the market value in the central government's favour exceeds an agreed amount (the threshold value). This threshold value will depend on the counterparty's rating, cf. Table 1.

The market value of swaps is compiled on a regular basis and as needed. If the market value less the pledged collateral exceeds the agreed threshold, the counterparty is required to pledge collateral.

Only collateral of DKK 10 million or more is transferred (reversed).

Permitted collateral will normally be government bonds with a rating of minimum Aa3/AA-. Other bonds can also be accepted, subject to individual assessment, e.g. Danish mortgage-credit bonds. The collateral value of the bonds is calculated as the market value after a haircut. Haircuts will depend on the remaining maturity of the bonds and must take account of the risk of a decrease in the value of the bonds.

The administration of bonds pledged as collateral to the central government is transferred to the custodian bank with which the securities are deposited. On behalf of the central government, the custodian bank will request the counterparty to provide additional collateral, should the collateral value of the deposited bonds decrease and become insufficient to cover the market value of the transacted swaps after deduction of the threshold. In the event of surplus cover, the custodian bank is equivalently authorised to release bonds to the counterparty.