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 high credit standing. A counterparty must normally be rated minimum Aa3/AA- by at least two well-reputed rating agencies (Fitch, Moody's or Standard & Poor's). 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 euro and currency swaps between kroner and euro, however, counterparties with a rating of minimum A3/A- are permitted.
Legal basis of agreement: Swaps are only transacted with counterparties that have signed an ISDA Master Agreement with appurtenant Credit Support Annex, which governs the business relationship between the central government and the counterparty.
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). The key elements of the agreements are:
- The agreements are unilateral, so that only the central government's counterparties pledge collateral.
- The government and the counterparty each calculate the market value of swaps and agree on the Credit Support Amount.
- Collateral is pledged when the market value in the central government's favour exceeds an agreed amount (the threshold value).
- 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 take into account that the value of the bonds can decrease.
- 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 value of the deposited bonds decrease by more than the minimum transfer amount and becomes insufficient to cover the market value of the transacted swaps after deduction of the threshold.
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 trans-acted. The same applies to transactions that include option elements, including swaptions, interest-rate caps, etc.
Netting: ISDA Master Agreements contain netting provisions whereby gains and losses on transacted swaps are set off if a counterparty de-faults on its payment obligations.
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 terminated should a counterparty's rating fall to a given level. In most of the central government's ISDA Master Agreements, the rating trigger is Baa1/BBB+1
Cross-default clauses: If the counterparty defaults on its payment obligations to a third party, cross-default clauses allow swaps to be terminated.
Observation list: The ongoing monitoring of the counterparty credit risk entails that counterparties assessed to involve greater risk are monitored more closely on an "observation list". Only in special circumstances are new swaps transacted with counterparties on this list.
[1] Some Master Agreements, dating from before the rating trigger requirement was formalised, have none or a lower trigger.
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