Commonfund Institute: “Hope is Not a Strategy”

(November 14, 2012) — Counterparty risk is an all-too-present danger-obvious in the ‘London Whale Losses,’ the LIBOR scandal, and the US Securities and Exchange Commission’s (SEC) revolving door of fraud cases-and it is the subject of the Commonfund Institute’s latest report.

“Counterparty risk is a fact of life, and it is unpredictable as demonstrated by sudden losses by some large financial institutions in recent years,” said David Belmont, Commonfund’s chief risk officer and author of the paper. He is responsible for all aspects of risk management for the institute. “The prevalence of fraud, uncontrolled trading losses, systems failures and control failures, when coupled with the complexity of our interconnected global financial market, makes counterparty risk difficult to anticipate and avoid,” he wrote in the paper.

Risk turns to loss swiftly in such cases, but there are things an institutional investor can do to protect the assets under their care, according to the paper. Belmont argues that best practices in this area need to start early-most of the shielding happens before anything is even signed.

Setting out a robust, explicit counterparty risk strategy is crucial, according to the author. He advises funds and investors to lay out a plan that includes the following:

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• Timely, detailed and enforceable documentation detailing specific terms of any transaction

• A clear and conservative counterparty risk policy

• Minimum counterparty-acceptance and contracting standards, to clarify what transactions fall under standard securities contracts

• Real time and market driven credit-quality monitoring

• Active counterparty-exposure measurement and limits

• Frequent and timely counterparty-risk reporting, which Belmont warns is often too late in arriving to be useful

• Predefined counterparty-risk mitigation and hedging plans

“Investors and fund managers need to define their counterparty risk strategy alongside their investment strategy if they are to maximize returns,” Belmont said. “Investors and fund managers can greatly reduce their credit exposure to counterparties by negotiating contracts that anticipate the potential default of a counterparty and set out mechanisms that limit potential exposure. In negotiating such contracts, appreciation of the implications of the governing legal and regulatory regime is essential.”

An ounce of prevention may be worth a pound of cure, but occasionally that cure does come in the form of a serious windfall.

Eleven public pension funds, including the California Employees’ Retirement System and Texas Teachers’, cashed in on Bank of America’s record $2.43 billion settlement of a recent class action lawsuit. The suit, which investors filed in 2009, accused Bank of America Merrill Lynch of unlawfully covering up the acquired bank’s $15.3 billion in losses from the fourth quarter of 2008.

(November 16, 2012) — Too often collateral is in the wrong place at the wrong time, according to a white paper by members of the European Union-based International Capital Market Association.

The authors of the paper foresee the demands of high quality collateral significantly outstripping supply in the future, and urge that it be treated as a scarce resource.

With demand and requirements up, the paper argues that IT infrastructure in the Eurozone is no longer up to the task of mobilizing assets and matching them with transactions.

“More attention urgently needs to be given to collateral fluidity, which in essence concerns the mobilisation of collateral, i.e. allowing it to be in the right place at the right time,” says the paper, which was produced by the Collateral Initiatives Coordination Forum, a subgroup of the larger trade association. “Achieving this requires that the plumbing be properly fixed, including through finally making progress with the continuing Giovannini barriers to EU cross-border clearing and settlement arrangements.”

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Since the financial crisis, collateral has been an increasingly important tool to protect against counterparty risk.

“This is in no small measure related to the shift in risk appetite of market participants, with an increased demand amongst them to secure their credit risk exposures through the taking of high quality collateral,” the paper says. “Official policy makers have also significantly fuelled the demand for high quality collateral as they have advanced steps to make markets more robust, to reduce systemic risk and help mitigate the risks of any future financial crises.”

While this whitepaper is from an EU-based industry group and focuses on the status of collateral in that continent, many of the same forces are at work in American markets. The Dodd-Frank financial reform act significantly increased incentives for collateralizing over-the-counter derivative transactions. This includes instruments commonly used by institutional investors, such as interest-rate swaps. The more collateral parties put up in a transaction, the lower their regulatory burden to the Securities and Exchange Commission.