Page 23 - ISLA_SLReport_Sep2019

Know Your Counterparts’

Creditworthiness (KYCC)

It is essential for all global capital markets participants Financial risk comes in many different forms, as the may also result from other problems associated with a in their counterpart selection in the interests of avoiding
to “know” the counterparts with whom they do business diagram below illustrates - the good news is that the risks counterparty unwilling to honour the contract.” risks that they cannot fully understand.
and factor these counterparts’ creditworthiness into their can all be understood and measured, and action can be
onboarding, risk management, capital, and operational taken to manage and mitigate them. Calculating counterpart credit risk typically involves The lack of CRA ratings for the supply-side (e.g. Sovereign,
decision-making. Irrespective of an organization’s position, the building of regulatory approved models (for Pension, Mutual and Insurance Funds) and demand side
whether on the buy side, sell side or as a principal/agent This short paper focuses upon the counterpart credit risk banks), requiring numerous detailed data inputs (e.g. Broker Dealers and Hedge Funds) of the industry,
intermediary, risks exist. Legacy processes such as the that occurs in the Securities Finance Industry. However, under the management of sophisticated and combined with the fact that the agents cannot provide
2006 Agency Lending Disclosure (ALD) are outdated and the approach outlined can be applied across the Capital experienced risk managers. CRA-style information to their clients without accepting
in need of revision. Forthcoming new regulations, such Markets and include counterparts such as: liabilities that they may not wish to accept (given that they
as the 2020 Securities Finance Transaction Reporting Recent research conducted by Credit Benchmark are not CRAs and their credit opinions are proprietary
(SFTR), are fast approaching. Therefore, the need for ‹ Central Clearing Counterparts (CCPs) has concluded that one of the largest counterpart risk and confidential) makes it challenging for the Beneficial
an efficient, new approach to bring operational, risk management challenges faced in Capital Markets is Owners to assess their counterpart risk accurately.
management and capital benefits has never been greater. ‹ Asset Managers in the counterpart ‘heavy’ Securities Finance industry.
Incorporating securities lending, repo and prime For reasons stated previously, many Beneficial Owners
Financial Risk ‹ Custodians and Sub-Custodians brokerage, this vital industry is at the epicenter of the and Hedge Funds do not have the capabilities in-house
Capital Markets. One of the key challenges is that many to assess and manage certain counterparts. However,
Market Risk Credit Risk Liquidity Risk Operational Risk ‹ Broker Dealers participants, in particular the numerous funds in this it is ultimately their decision to make as they are often
industry, have been hitherto unrated by the traditional principals in the transactions. Ironically, they often
Asset ‹ Execution Brokers Credit Rating Agencies (CRAs). This means that the struggle with counterparts that look quite like themselves
Absolute Risk Credit Event Fraud Risk
Liquidity
participants have had to take responsibility for the – A.K.A. their “peers”, because they have no CRA rating.
Sovereign Funding ‹ Exchanges complicated undertaking of counterpart risk assessment
Relative Risk People Risk
Risk Liquidity
themselves, or otherwise adapt their behaviour. Counterpart Restriction: Securities Finance participants
Settlement
Directional Model Risk Counterpart Credit Risk is defined as: could choose to restrict their counterparts to those with a
Risk
Given that calculating and monitoring counterpart CRA rating above a certain level – which constrains their
Non-Direc- Legal Risk
tional “The risk that a counterparty to a transaction or contract creditworthiness in-house requires a significant resource business opportunities and reduces the performance of
will default (i.e. fail to perform) on its obligation under the commitment, it is a function that banks are often best their lending programme via their agent (if they have one).
Basis Risk
terms of the contract between the parties. Counterparty placed to meet. Many non-bank principal participants This approach will potentially have negative commercial
risk is not limited to credit risk (the risk that the counterparty are left to rely on their best in-house efforts, dependent implications – with perfectly sound counterparts
Volatility Risk
cannot fulfil its contractual obligations for payment) but upon incomplete information from the CRAs, or restricted possibly being excluded from their counterpart list and
22 23