Chapter 11
Credit Risks on Swap Counterparties
11.1 Summary
Since 1983 the central government has used swaps to reduce the costs of borrowing, and to manage the currency
distribution and interest-rate risk on the debt.
Swaps can entail losses in the event of default by the swap counterparty. It is sought to limit the credit risk on swap
counterparties via a restrictive credit policy, and via ongoing monitoring of the credit risk on the counterparties. There
have been no cases of counterparty default on obligations concerning swaps transacted with the central government.
In spite of the requirement that the counterparty to a swap must have a high credit standing, the risk of default can never
be eliminated completely. For this reason, the central government now requires counterparties to sign a collateral
agreement whereby market values of transacted swaps which exceed a threshold value in the central government's
favour are covered by collateral.
In order to achieve the full benefit of the collateral agreements, in conjunction with the establishment of the agreements
certain adjustments have been made to the central government's credit-risk management of the swap portfolio.
Moreover, the agreements have led to a revision of the way that the credit exposure on swap counterparties is
calculated.
Notwithstanding the collateral agreements, it is still considered important that all swap counterparties have a high credit
standing. For this reason, the central government's ISDA Master Agreements with the counterparties include rating
triggers and cross-default clauses. These provisions make it possible for the central government to terminate the swaps
prematurely, should the counterparty's rating (credit standing) be downgraded to an unsatisfactory level, or should the
counterparty face liquidity problems.
11.2 Credit-risk management of swap counterparties
Background to credit-risk management of swap counterparties
A swap is a contract whereby two parties agree to make payments to each other which are equivalent to each party
having raised a loan from the other party. When a swap is transacted the market values of the payments (cash flows)
which the parties agree to exchange will normally be equal. However, fluctuations in interest-rate levels and exchange
rates lead to the net market value of the swap normally differing from zero. If one party fails to honour its payment
obligations in the swap, e.g. due to compulsory liquidation, the other party will incur a loss, if the market value of the
swap is positive for the latter.
It is considered very important to keep the credit risk on swap counterparties at a very low level. To date, the central
government has not incurred any credit loss on a swap counterparty as a consequence of default. Chapter 6 concerning
risk management presents the central government's swap portfolio and the credit risk thereon.
To maintain a low credit risk on the swap portfolio, a restrictive credit policy for the central government's use of swaps
has been formulated. The credit policy includes a number of specific rules designed to minimise the credit risk by
limiting:
- the credit exposure on the counterparty
- the probability of default by the counterparty, and
- the expected loss in the event of counterparty default.
Appendix 11.A presents the key elements of the central government's credit policy.
It is important to emphasise that the explicitly formulated credit policy can never stand alone. The central
government bases its approval of counterparties on ratings and therefore e.g. finds it necessary to monitor
continually whether the rating agencies' ratings are a relevant measure of the credit risk. The crisis in Southeast
Asia in 1997 thus showed that in certain cases there is a lag in the rating agencies' downward adjustment of their
ratings.
Collateral agreements
The most important expansion of the central government's credit policy in recent years is that now swaps can
only be transacted with counterparties with whom a collateral agreement has been, or is close to being,
established.[1]
The loss on an uncollateralised claim on a counterparty that defaults can be considerable. However, the size of
any possible loss can be reduced significantly if the claim is secured with collateral of high quality.
The central government's collateral agreements are established as Credit Support Annexes to the ISDA Master
Agreements which on an overall basis regulates the relationship between the central government and the swap
counterparties. The principal elements of the annexes are:
- The annexes are unilateral, so that only the central government's counterparties can be required to provide
collateral.
- Collateral does not have to be provided until the market value in the central government's favour exceeds an
agreed amount (the threshold value). The threshold value will depend on the counterparty's rating, cf. Table
11.A.1.
- The market value of swaps is revaluated on a regular basis. Should a revaluation of swaps show that the market
value less existing collateral exceeds the threshold value, the counterparty is required to pledge further collateral
to the central government.
- Additional collateral is only required to be transferred (carried back) if the collateral shortfall (surplus) is DKK
10 million or more.
- Appropriate collateral is normally government bonds with a rating of minimum Aa3/AA-. Other bonds, e.g.
Danish mortgage-credit bonds, can also be accepted, subject to concrete evaluation. The collateral value of the
bonds is calculated as the market value after a price deduction (haircut). Haircuts will depend on the remaining
maturity of the bonds and must take the risk of depreciation in the bonds' market value into account.
- In addition to bonds, bank deposits are also authorised collateral. The cash must be deposited with a bank with a
minimum rating of Aa3/AA-. The bank in question cannot have close links with the counterparty.
- The administration of bonds pledged as collateral to the central government is transferred to the custodian bank
with which the collateral is deposited. On behalf of the central government the custodian bank will request
additional collateral from the counterparty if the collateral value of the deposited bonds is insufficient to cover the
market value of transacted swaps after deduction of the threshold value. In the event of surplus cover the
custodian bank is likewise authorised to release bonds to the counterparty.
By setting a threshold for the uncollateralised proportion of the actual credit exposure the collateral agreements
have led to a significant reduction of the expected losses in the event of counterparty default. In addition the
agreements have also led to a reduction of the potential (future) credit exposure on counterparties.
Section 11.3 reviews the handling of collateral agreements. The significance of the agreements to the credit
exposure and thereby the credit risk on the swap counterparties is described in further detail in section 11.4.
Terms and conditions for early termination of swaps
Another area in which the central government's credit policy has been formalised concerns the opportunity
to terminate swaps prematurely should a counterparty's credit standing become unsatisfactory, or the
counterparty face liquidity problems. It is now a requirement that ISDA Master Agreements with
counterparties include a cross-default clause, as well as a rating trigger.[2]
A cross-default clause enables the central government to terminate swaps should a counterparty default on
payment obligations to a third party. The clauses will normally be formulated in such a way that they can
only be activated in the event of payment default which complies with certain criteria, e.g. size, cause, etc.
The significance of rating triggers to the central government's credit risk is reviewed in section 11.5.
11.3 Handling of collateral agreements
Outstanding claims and thereby credit risks derived from e.g. swaps increased to a very high level in global
terms during the 1990s. Therefore major banks, primarily in the USA, began to establish mutual
agreements on securing this type of claim with collateral. This requirement arose in recognition of the fact
that swaps are often long-term transactions whereby, in certain cases, the counterparty could face serious
difficulties even if its credit standing had previously been satisfactory. In recent years the use of collateral
agreements has become more common and is now also applied by a number of central governments and
supranational institutions.
As a consequence of this trend ISDA (International Swaps and Derivatives Association) has issued
recommendations for the handling of collateral agreements on claims derived from swaps, etc.[3]
As stated, the collateral agreements have led to a significant reduction of the central government's credit
risk on swap counterparties, cf. Chapter 6. However, it must be emphasised that collateralisation is a
supplement to, and not a substitute for, the ordinary credit-risk management of counterparties. The
agreements thus do not entail any cover for the market value which is below the agreed threshold value.
The collateralisation also entails other types of risks. These must also be managed in order to obtain the
full benefit of the agreements. This applies to risks related directly to the value of the pledged collateral, cf.
Box 11.1, as well as to operational risks linked to the handling of the collateral agreements. However, the
size of these risks is assessed to be moderate in comparison to the reduction of the credit risk resulting
from the agreements.
Box 11.1 Risks derived from collateralisation
Credit risk: The collateral value of securities depends on the credit standing of the issuer. This means that for
bonds there will often be a minimum rating requirement for being eligible as collateral.
The central government accepts only bonds with a rating of minimum Aa3/AA- as collateral.
Correlation risk: In certain cases the collateral value of an asset may seem satisfactory. However, the collateral
value can be limited by the fact that the value of the asset is positively correlated with the counterparty's credit
standing.
This risk is of no great significance to the central government, since primarily only government securities are
accepted as collateral.
Market risk: If the collateral is e.g. bonds a rise in interest rates will entail a loss, whereby the value of the
collateral falls below the market value of the swaps to be covered. The collateral value of the bonds is therefore
normally fixed at the market value less a "haircut". Haircuts are related to the interest-rate risk on the bonds, as
well as how quickly the bonds can be realised, if necessary.
The haircut applied to the central government's calculation of the collateral value of received bonds is in the range
of 2 to 8 per cent. In the central government's agreements the interest-rate risk is also often limited by setting a
maximum remaining maturity for received bonds.
Liquidity risk: There is a risk that the value of the collateral is subject to pressure on realisation. Illiquid bonds
should therefore either be excluded from the collateral basis or a particularly high haircut should be deducted
when calculating the collateral value.
The central government's agreements are drawn up in order to avoid as far as possible counterparties providing
illiquid bonds as collateral to the central government.
Legal risk: The pledging of collateral will be based on legal agreements. Uncertainty concerning the validity of the
agreements, as well as the opportunities to exercise the agreements, are described as legal risk on collateral.
An example of legal risk concerns the netting provisions of the central government's ISDA Master Agreements.
According to these provisions, the central government may undertake netting of gains and losses on various swap
contracts with a counterparty which defaults. This significantly reduces the collateral requirement. If the netting
provisions – against expectations – are not legally sustainable, the collateral requirement will be significantly higher.
In that case the risk of loss constitutes the gains on a gross basis, without deduction of any losses.
Another example of legal risk is a court's reversal of the mortgagee's realisation of collateral on the grounds that
the deed of security was not complete. By deed of security is meant the procedures to be observed for it to be
possible to invoke a pledge vis-à-vis other creditors).
Concentration risk: The securing of large-scale credit exposures with the same asset can entail a reduction of the
collateral value of the asset. For the individual credit exposure the concentration risks on an asset will particularly
comprise liquidity risk. The concentration risk on an asset for the overall credit exposures include credit risk.
Concentration risks are not assessed to be of any great significance to the central government's agreements.
With regard to the handling of the collateral agreements, the settlement of disputes presents a particular
problem. In periods of unrest on the financial markets two parties may disagree on the market value of a
swap portfolio, and thereby on the size of the collateral one party is required to provide to the other.
ISDA states that disputes can often be attributed to dissent concerning:
- the rates/parameters to be applied to the revaluation of swaps (especially relevant for structured or illiquid
swaps),
- choice of revaluation time (should the basis be close of business in London, Copenhagen or New York?),
- the contracts covered by the collateral agreement (especially a problem for large portfolios not subject to automatic reconciliation), and
- the procedures to be followed on requests for and transfers of collateral (especially a problem if the terms
and conditions of collateral agreements are not followed consistently).
The collateral agreements set out some very general terms and conditions for settlement of disputes
concerning the market value of swaps. However, these are applied only rarely, probably because they
require the involvement of third parties. The third parties will thus gain insights on the internal affairs of the
parties, which may be less appropriate in the case of third parties that are competitors. ISDA therefore
recommends its members to establish guidelines to ensure the informal settlement of disputes, including the
revaluation of swaps' market value.
Another issue is that the transfer of collateral may be delayed, with the result that for a period credit
exposure may be unsecured, even though the terms and conditions stipulate that collateral should be
pledged. One solution might be to pledge cash deposits, which can normally be transferred quickly
between the parties, as temporary collateral.
ISDA also states that the growing use of collateral agreements in relation to swaps and other derivatives
may lead to a need to increase the types of securities that can be pledged as collateral. Today there is a
tendency to concentrate collateral on a few categories of assets.
to be continued on next page
Footnotes
[1] Since September 1999 14 counterparties have signed a collateral agreement. This means that 60 per cent of the swap portfolio is covered by a collateral agreement. Swaps with counterparties who do not wish to establish a collateral agreement will normally continue on the originally agreed terms. This implies that it will take a number of years for all swaps to be subject to collateral agreements. It is expected that the central government will sign at least 5 new agreements during 2001, whereby the ratio covered will rise to approximately 80 per cent.
[2] In certain cases the central government also takes the initiative to reduce the credit exposure on a counterparty even if a rating trigger or a cross-default clause is not activated. An example is described in Chapter 6.
[3] The recommendations are reviewed in ISDA 1999 Collateral Review. This report was followed up with ISDA Collateral Survey 2000, which reports on how the recommendations are followed among 46 market participants, primarily major internationally operating banks. Some end-users, including the Danish central government, also participated in this survey. Moreover, in 1998 ISDA published Guidelines for Collateral Practitioners, which gives a general introduction to the use of collateral to manage the credit risk on derivatives. The reports can be viewed at www.isda.org/publications.
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