Reducing credit risk inover-the-counter derivatives

John P. Behof

During 1992, there has beenmuch discussion of the stagger-ing size and dramatic growth inthe use of derivative and offbalance sheet financial prod-

ucts and the potential risks these productspresent to the global financial system. A num-ber of events in particular have led to greaterconcerns surrounding management of credit riskarising from derivative and off balance sheetproducts. While the term "derivatives" is usedto describe a variety of nontraditional financialinstruments such as interest rate swaps, financialfutures, and options, most risk concerns arefocused on the proliferation of over-the-counter(OTC) products which bear direct counterpartycredit exposure. OTC derivatives include amyriad of swap and option products linked tointerest rates, currencies, equities, and commodi-ties. Unlike exchange traded futures and optionscontracts with margin requirements, OTC offbalance sheet products incur credit risk due tothe potential default of the counterparty prior tocontract maturity.

The bankruptcy of Drexel Burnham Lam-bert and the subsequent failures of the Bank ofNew England, Development Corp. of New Zeal-and, and British & Commonwealth MerchantBank caused many market participants, especial-ly corporations, European users, and investmentfunds, to restrict their OTC derivatives creditexposure to only AAA and AA firms) Themore recent bankruptcies of Olympia & Yorkand other corporate entities with fairly substan-tial derivative books further illustrated the dan-gers in conducting OTC derivatives business

with weak corporate counterparties outside ofthe interbank arena.

Besides the actual bankruptcies that haveoccurred, many other firms have been down-graded recently, causing credit sensitivity inOTC derivatives to increase substantially. Otherfactors contributing to the recent credit concernsinclude the increasing complexity and maturityof the deals, the increased participation of weak-er corporations, uncertainty about legal reme-dies, and increased difficulty in judging thecreditworthiness of derivatives users due tocurrent accounting rules.'

These credit constraints have the potentialto impact the number and nature of market par-ticipants as well as impede the dramatic growthof off balance sheet financial products. Majorcommercial and investment banks that havebeen downgraded have already lost market shareand fee income from high margin corporatecustomers that are in some cases authorized todeal with only AAA or AA firms. The remain-ing AAA and AA market makers are also reduc-ing their exposure to the downgraded firms,threatening the ability of lesser rated entities toparticipate in these markets safely and profit-ably. These pressures could trigger a migrationto exchange traded markets, especially in light ofthe fact that recent regulatory changes will likely

John P. Behof is a Senior Examiner in the Depart-ment of Supervision & Regulation at the FederalReserve Bank of Chicago. The author is especiallygrateful for assistance by Barbara Kavanagh, Fi-nancial Markets Officer. The author would alsolike to thank Herbert L. Baer, Garrett Glass, JohnStocchetti, and Ken Wiersum for their insightfulcomments.

FEDERAL RESERVE BANK OF CHICAGO 21

allow futures exchanges to list OTC products aswell as the already listed contracts which can beused as substitutes. 3

As a result, derivative market participantshave devised new methods for dealing withincreased credit risk as well increased usage ofmore established methods. These may generallybe divided into the following categories: (a)formation of a special purpose vehicle (SPV) orspecial operating subsidiary with a higher creditrating than the parent; (b) collateralization ofcredit risk; (c) cash settlements, assignments,and unwinds; (d) netting of obligations, bothbilaterally and multilaterally; and (e) third party"portfolio" support, such as pool insurance,letters of credit, or guarantees. Some creditreducing techniques, such as bilateral netting andcollateral agreements, have been used for yearsby a minority of counterparties to aid in theirexecution of trades with each other. Others,such as SPVs and multilateral netting are morerecent innovations. The successful implementa-tion of any of these credit reducing techniqueswill determine whether these markets experiencecontinued growth or stagnate under the weightof credit constraints. This article will describeand analyze some of the more notable attemptsat reducing credit exposure in derivatives.

Special purpose vehicles

The use of special purpose vehicles (SPVs)as a credit enhancement in derivatives is in someways analogous to securitization. Over the pastfive years, several institutions of less than AAArating have found securitization to fund certainassets to be cost effective. In a traditional secu-ritization structure, a separate organization,usually a trust, is established to isolate the assetsin question from the overall risk of the origina-tor. Establishing corporate separateness is es-sential for three reasons: to allow the SPV toobtain a separate, higher rating; and to insurethat, in the event of bankruptcy or insolvency ofthe parent, the SPV could avoid having its assetsand/or cash flows made part of the bankruptparent by "substantive consolidation;" and toassure the parent's creditors or regulators thatthere is no recourse to the parent.

A classic securitization is the conveyance ofa pool of assets to the trust, with the credit riskof the pool partially insured by a mechanismsuch as a reserve for losses, letter of credit, etc.In the case of derivatives, SPVs have generallybeen established to isolate a product line pro-

spectively. A review of two SPVs established todate by major investment banking firms illus-trates this.

Both Goldman Sachs Equity Markets L.P.and Merrill Lynch & Co. have established andcapitalized SPVs to improve their trading prod-ucts' capabilities. In each instance, the parentcompany has contributed significant capital tothe newly formed entity. Both SPVs obtainedAAA ratings whereas the parent firms had A+senior unsecured debt ratings. The level ofcapitalization in each, together with certain othersteps taken to effect corporate separateness andcontain the level of credit and market risks in-digenous to the portfolios, allowed the SPVs toattain separate, higher ratings.

In the case of Goldman Sachs, GS FinancialProducts International, L.P. (GSFPI) takes thelegal form of a limited partnership. It was ini-tially capitalized by a parental contribution of aportfolio of in-the-money yen denominatedoptions and warrants on the Nikkei 225 stockindex valued at approximately 9.3 billion Japa-nese yen. In the case of Merrill Lynch, MerrillLynch Derivative Products, Inc. (MLDPI) is alegally independent subsidiary capitalized via$300 million in common stock issued to MerrillLynch and a $50 million preferred stock issueplaced with a third party. With each vehicle,additional elements are present to insure corpo-rate separateness that include all or some of thefollowing: some element of management anddirectorate independence, operating and ac-counting safeguards, and ongoing, independentaudit or third party oversight.

Credit and market risk associated with theSPVs existing and/or prospective business islimited by setting certain preestablished parame-ters within which business will be conducted.Counterparties need to meet certain de minimusstandards designed to insure diversification andto limit risk taking. These include the creditrating of counterparties, exposure to an individu-al counterparty, limits on aggregate exposure toa class of a given rating category, and limits ondiversification of country risk by country oforigin of counterparty. Credit quality can alsobe maintained through various capital targetswhich become increasingly restrictive as coun-terparty ratings decline and probability of defaultincreases.

Equally important are the terms of suchother factors as market, currency, and/or interest

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rate risk exposures. MLDPI is chartered to enterinto interest rate and currency swaps, caps andfloors, and interest rate options. Each swapMLDPI enters into with a customer will be mir-rored by a swap with the opposite payment char-acteristics from Merrill. MLDPI will thereforenot be directly exposed to fluctuations in interestrates or exchange rates.' Since Merrill's ratingof A+ makes it the lowest rated counterpartyconducting business with MLDPI, the latter isprotected by a requirement that Merrill collater-alize its net position with MLDPI. The ability toprovide collateral on a net basis is one reasonSPVs are more attractive than executing separatecollateral agreements with each counterparty.

As of this writing, there are several com-mercial banks contemplating the establishmentof SPVs in the form of operating subsidiaries tohouse at least a portion of their derivatives busi-ness. The creation of SPVs by banks raisesseveral new regulatory issues.

(a) Bankruptcy remoteness: in the case of acommercial bank, the issue is whether, in theevent of insolvency of the associated bank, theFederal Deposit Insurance Corporation (FDIC)would recognize the derivatives subsidiary asbeing a separate entity or instead consider it partof the institution in receivership. As of thiswriting, it is unclear whether the rating agencieswill rate bank derivative product subsidiariesAAA without some form of assurance from theFDIC that they will in fact be treated as "bank-ruptcy remote."

(b) Capital adequacy: clearly the MerrillLynch and Goldman SPVs were begun withsubstantial capital contributions from their par-ents. The ability of commercial banks to con-tribute such sums and remain adequately capital-ized as independent entities will be subject toreview. In addition, movement of collateralfrom the bank to the SPV will be required in theevent the value of the bank's position deterio-rates or if one of the SPV's counterparties isdowngraded. In the proposals to date, the deriv-ative subsidiaries are structured as operatingsubsidiaries of the commercial bank so that anyequity contributed to the subsidiary could be"recaptured" in the accounting consolidationprocess. The question becomes one of whetherconsolidation of allocated capital should bepermitted for risk capital adequacy purposes.

(c) Preemption of the FDIC and unsecuredcreditors: the question arises of whether unse-

cured creditors of the bank establishing the de-rivatives operating subsidiary are effectivelydisadvantaged by a portion of capital beingallocated to the subsidiary. In the case of com-mercial banks, the ultimate unsecured lendercould be the FDIC.

The proponents of bank SPVs recognizethese issues as important, but believe they arenot exclusive to derivative subsidiaries for thefollowing reasons. First, the establishment ofbankruptcy remote entities by banks is not a newconcept and the legal precedent for corporateseparateness is well established. Second, theconsolidation of nonderivative operating subsid-iaries for the "recapture" of risk based capital isa regularly accepted practice, except for bankholding company subsidiaries (Section 20 sub-sidiaries) that are involved in "bank ineligible"securities underwriting activities which havebeen allowed by the Federal Reserve Board on alimited basis since 1987. 5 However, the combi-nation of a bankruptcy remote entity which isalso an operating subsidy is a new concept.Finally, the preemption of the FDIC and otherunsecured creditors can be accomplished effec-tively through a number of other collateralizedactivities already conducted by banks, includingexchange trading, unilateral, bilateral, and multi-lateral collateral agreements, as well as repur-chase agreements and membership in clearing-houses. For example, if a bank were taken overby a government agency, it is unlikely the agen-cy could repudiate an obligation to a third partyand expect that party to return the collateral itheld as security for the obligation.

Although SPVs are in their infancy, marketparticipants note that each of the vehicles estab-lished to date are reported to be successfullybooking business with corporate users and OTCmarket participants. However, two negatives ofSPVs have been noted. First, some corporationsdo not believe the AAA SPVs are truly AAAand will "look through" the vehicles to the par-ent's credit rating. Second, some corporationsare not agreeing to have their trades reassignedout of the SPV in the case of their own down-grading.

Bilateral netting

Banks and other derivative market partici-pants have been more aggressively pursuingnetting agreements, both bilateral and multilater-al, as a reaction to credit concerns. The abilityto net obligations within product groups, such as

FEDERAL RESERVE BANK OF CHICAGO 23

foreign exchange and interest rates commodities,has been the focus of the vast majority of theseattempts, although cross product netting betweenderivative types is becoming more prevalent.For example, if Bank A was owed a net presentvalue of $50 million on interest rate swaps byBank B, but owed $25 million in currency op-tions to Bank B, netting the two obligationswould reduce credit risk by half. Some crossproduct netting agreements have gone so far asto include the netting of nonderivative obliga-tions such as loans with net derivative balances,but these are very rare. Some large banks haveindicated that having derivative bilateral nettingagreements with approximately a dozen largecounterparties could reduce credit risk by asmuch as 50 percent.

Bilateral netting agreements can generallybe divided into four categories: netting by nova-tion, close out netting, payment netting, andcross product netting.

Netting by novationNetting by novation refers to a legally bind-

ing netting where matched pairs of trades be-tween counterparties are superseded by subse-quent trades—in effect, a running balance isoperative.° The Financial Institutions Reform,Recovery, and Enforcement Act of 1989 (FIR-REA) specified several "qualified financialcontracts" and how netting of these contractswould be treated in receivership or conservator-ship for U.S. depository institutions. This al-lowed institutions to comfortably participate inwritten novation agreements for most derivativecontracts with U.S. depository institutions with-out much worry of regulatory repudiation.

Netting by novation has been popular withforeign exchange contracts because large num-bers of matched trades typically exist (samecurrency, same settlement date, same counter-party), although spot foreign exchange was notspecifically mentioned in FIRREA. In interestrate products and other OTC derivatives, howev-er, netting by novation is less common sincetrades with matching terms are more unusual.Since principal is not exchanged, it is the period-ic payments that fall on the same settlement datewithin the same product line which are novated.It would appear, however, that the desire toutilize netting by novation in a credit sensitiveenvironment may encourage more standardiza-tion in these products.

Regulators have expressed concern that thelarge growth in outstanding notional principalvalue in derivative markets has been accompa-nied by a commensurate amount of growth ofthe risk in these markets. The trend towardnetting schemes, however, has the power toreduce real credit risk relative to the size ofnotional values. Using the outstanding notionalprincipal as a proxy for risk will become evenmore tenuous as legally enforceable nettingenvironments proliferate. In countries where itis known to be enforceable, netting must beviewed as a powerful credit enhancer and maybecome even more prevalent in the years ahead.

Close out nettingClose out netting is a netting procedure

which becomes operative only in the event oneor both of the counterparties defaults on its obli-gations or a triggering event takes place, such asa downgrade. Although close out netting agree-ments used to be mostly stand alone agreements,they are increasingly becoming part of masteragreements. The current International SwapDealers' Association (ISDA) master agreement,a bilateral agreement typically used betweeninterest rate derivative counterparties, definesthe methodology by which all contracts betweenthe party and the counterparty will be netted to asingle number in the event of a default. In addi-tion, the standard swap agreement has a provi-sion which states that a default on any singleswap or derivative obligation between the coun-terparties triggers termination of all derivativecontracts between the counterparties, thus pre-venting "cherry picking" (that is, demandingpayment for trades with positive mark to mar-kets and reneging on trades with negative markto markets) by counterparties. Once terminationis triggered, all positions are marked to marketand any payments owed to the defaulting partyare netted against payments owed by the default-ing party before settlement is made.

Changes in the bankruptcy laws in the Unit-ed States in 1990 made close out netting in de-rivatives standard procedure for corporate enti-ties, while the FDIC Improvement Act of 1991(FDICIA) clarified the enforceability of closeout netting and netting by novation in deriva-tives for depository institutions. By being evenmore specific about the protection from cherrypicking by regulatory conservators and counter-parties, FDICIA improved what FIRREA hadbegun. Since FIRREA states that close out

24 El.(1 \ 0\114. 'I IN ES

netting will be accomplished using net presentvalues, it lessened significantly the credit riskassociated with long term financial contracts.FDICIA does not limit the netting procedures to"qualified financial contracts" like FIRREA,thereby opening the door for cross product net-ting of financial contracts with other more tradi-tional obligations. FDICIA does, however,contain stringent documentary requirements forcounterparties, consistent with FIRREA and theBankruptcy Code for corporations.

Payment nettingPayment netting or "position netting" is an

unwritten arrangement between two counterpar-ties to net the payments arising from two ormore derivative transactions on which paymentsare due on the same day. A written agreement tonet payments would be considered netting bynovation. In either case, the underlying creditrisk from mark to market values is unchanged,because they remain legally obligated for thegross transactions.' The number of settlementmessages are also reduced, as are the amountof funds needed for routine settlements. Thevalue of informal payment netting is unclear,however, because whether it is legally bindingremains untested.

Cross product nettingAs previously mentioned, netting across

derivative product categories has been experi-mented with for the last several years, whilenetting derivatives with nonderivatives is justbeginning. For example, suppose XYZ Corpo-ration has an exposure to Bank A. In order toensure that Bank A could perform, it grants aloan or credit line to XYZ Corporation. Theloan or credit line would be in the same amountas the exposure, with the credit line only beingdrawn upon by Corporation XYZ if Bank Aappeared to be in trouble. With a cross productnetting agreement, if Bank A is taken over by afederal agency, Corporation XYZ's exposure onthe derivative would be netted against the loan,and therefore the net exposure would be elimi-nated. Although potentially a powerful creditenhancer, this type of arrangement may facecriticism as it could strain bank liquidity when itwas needed most. Surely, as this type and othertypes of cross product netting schemes come tolight in the next few years, there will be muchdebate as to whether their benefits are out-weighed by other risks they may introduce.

The legal implications ofbilateral netting

The legal enforceability of bilateral nettingagreements is paramount in order to effect anyrisk reduction in the case of counterparty bank-ruptcy. It has been substantially enhanced in theU.S. by recent amendments to the United StatesBankruptcy Codes (1990), FIRREA, and FDI-CIA for depository institutions. The ability ofconservators to cherry pick has been severelyrestricted in the U.S. by these legislative chang-es, but only if written bilateral netting agree-ments exist. Section 212 of FIRREA states thatno person will be prohibited from exercising hisor her right to net obligations of any qualifiedfinancial contracts with depository institutions inconservatorship or receivership. FIRREA de-fined qualified financial contracts as any securi-ties contract, commodity contract, forward con-tract, repurchase agreement, swap agreement,and any similar agreement.'

Despite the legal changes incorporated inFIRREA and the bankruptcy code, some uncer-tainty remained. For example, since the quali-fied categories were so broadly defined, it wasnever made clear whether spot foreign exchangecontracts were included. In addition, it was alsonever made clear whether netting would bepermitted across categories of individually quali-fied contracts. FDICIA's approach, however, isto look at the type of contracting party, not thecontract. Any kind of agreement between finan-cial institutions in which parties agree to netpositions subject to certain contingencies wouldbe considered a qualified netting contract. Un-der FDICIA, the Federal Reserve Board maydetermine what is a financial institution and iscurrently determining whether insurance compa-nies, swap affiliates of broker-dealers, nonbanksubsidiaries of banks and bank holding compa-nies, or other entities will be included in thedefinition. 9

Outside of the U.S., the legal enforceabilityof netting is not as straightforward. The Lam-falussy Committee on Interbank NettingSchemes concluded in its 1990 report that bilat-eral master agreements and other bilateral net-ting by novation or current account agreementsare likely to be enforceable in countries wherethe 1988 Basle Accord is in effect.'° The ISDAhas obtained legal opinions from counsel inBelgium, Canada, France, Germany, Italy, Ja-pan, the Netherlands, Sweden, and the United

FEDERAL RESERVE BANK OF CHICAGO

25

Kingdom indicating that netting provisions con-tained in bilateral master agreements were likelyto be upheld in each of those countries." Unfortu-nately, constructing legally enforceable nettingagreements, considering the sometimes conflict-ing legal structures of different countries, is oftenat odds with the attempts to standardize suchagreements. Also, because so few derivativefirms have gone bankrupt, different degrees ofcomfort are taken from reasoned legal opinions,especially when the more esoteric derivatives areinvolved and countries with less clear legal prece-dent are involved. In addition, regulatory authori-ties have expressed concern over the enforceabili-ty of netting agreements during an internationalfinancial crisis, which would have potentiallywidespread systemic implications.

Although they can be somewhat expensiveand difficult to execute, bilateral netting agree-ments are gaining popularity as an immediateremedy to credit constraints, particularly sincemultilateral clearinghouses appear to be a year ortwo away from establishment. Until recent intro-duction of more standardized documents, stan-dardized bilateral netting agreements were usuallycustomized documents or somewhat customizedversions of the ISDA master agreement whichwere negotiated by the attorneys from each coun-terparty. As bilateral netting agreements havegained popularity, more standardized agreementsare appearing. ISDA has developed a standard-ized bilateral close out netting agreement which ispart of the so called multiproduct master masteragreement which has recently been completed.Other agreements used in the market which haveprovisions for bilateral netting include the Interna-tional Currency Options Market Master Agree-ment and Guide (ICOM), the New York bankforeign exchange master, the PSA agreement forbond options and repurchase agreements, thecross border Canadian foreign exchange agree-ment, and FXNET. In addition, the ICOM groupis preparing an agreement for foreign exchangespot and forward transactions which will includenetting provisions. None of these netting docu-ments has yet emerged as a clearly preferreddocument within the financial industry.

Collateral pledging for OTC derivatives

Recently, many interbank derivatives marketparticipants have established unilateral and bilat-eral collateral agreements or margining agree-ments among themselves and with corporatecounterparties. In short, bilateral collateral agree-

ments require two way movement of assets, thatis, the positions are marked to market and thedebtor counterparty pledges cash or securities tothe contra counterparty. Unilateral agreementsrequire one counterparty to deliver collateral ontrades with negative mark to markets but not theother, presumably because one counterparty isless creditworthy. Theoretically, if the debtorcounterparty that pledged collateral was to de-fault, the contra counterparty would take posses-sion of the collateral. This system is analogousto the futures exchanges' mark to market system.In a futures system, participants with positivemark to market positions receive cash. Under acollateral agreement they are pledged assets.

Bilateral collateral agreements have becomepopular with downgraded interbank participantsbecause they allow them to continue to tradeamong themselves, while capping, or limiting,attendant credit exposure; unilateral agreementshave allowed weaker corporations and thrifts toparticipate in OTC derivatives. In general, thehighest rated interbank players (AAA, AA) havepreferred to trade among themselves and withhighly rated corporations and have not to datebeen active in establishing interbank collateralagreements. Recently, however, more highlyrated participants have been attracted to theconcept in order to facilitate trades with lowerrated counterparties and increase volume withhigher rated counterparties.

One question is whether the cost of collater-alizing losing trades would prohibit widespreadacceptance of the concept. Investigation shows,however, that the cost can be made manageable.Several cost cutting methods are in use.(a) High thresholds for movement of collateral

(usually several million dollars) eliminate theneed to move collateral in the case of smalllosses. High thresholds decrease the proba-bility that collateral will move, but allow forprotection against large credit losses andreduce costs significantly. In many cases, thecounterparty with the higher credit rating mayhave a higher threshold or point at whichcollateral need be pledged than the lowerrated counterparty. This system of uneventhresholds allows lower rated interbank par-ticipants to avoid unilateral collateral agree-ments. Uneven thresholds also allow for thepossibility that the lower rated bank mayreceive collateral. In cases where creditwor-thiness is of great concern, a negative thresh-

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old is established. Collateral is pledged on anexisting deal in which the debtor's mark tomarket value approaches zero but is not yetnegative. When a negative threshold is ineffect, some initial collateral may be requiredon day 1 because the mark to market valuewould already be near zero for the weakercounterparty on the day the contract is exe-cuted.

(b) Triggering events such as rating agencydowngrades or lower capital ratios can beused to initiate collateral movements. Thistype of advance agreement can reduce sub-stantially the operational costs of movingcollateral regularly while maintaining signifi-cant protection from losses.

(c) Commingling of funds allows the collateralrecipient to earn some interest on the collater-al to defray the cost of its collateral outlays.In this respect, cash collateral is treated like apledged bank deposit and security collateralwould be available for repledging by theholder. However, some collateral agreementsprohibit repledging of securities or commin-gling of funds.

(d) Security substitution or rehypothecationprovides even greater flexibility and less cost.For example, debtor counterparties may useterm repurchase agreements (repos) to obtaincollateral, that is they would make a shortterm loan to a third party and receive securi-ties as collateral for the loan. These securitieswould then be pledged to the derivative con-tra counterparty as collateral on the derivativeposition, which could be long term. Withrehypothecation, the debtor may substitutealternate securities or cash with the derivativecontra counterparty when the repo term is upor at any time, thus allowing the most costeffective use of collateral. The followingexample illustrates these transactions.

Suppose Bank A is the debtor counterpartyand must pledge collateral to the contra counter-party (Bank B). After comparing all the interestrate swap contracts between Bank A and BankB, Bank A has a negative mark to market of $12million with Bank B. (In other words, interestrate movements since the time of initially enter-ing into these contracts have been in favor of B,thereby leaving it with credit risk exposure toBank A.) The collateral threshold, however, is$10 million. Bank A is therefore required to

pledge $2 million collateral to Bank B. Bank Acould deposit $2 million cash in a bank accountat Bank B and earn the interest. Bank A couldalso send securities that it already owns.

Those already collateralizing transactionsbelieve that the collateral agreements describedabove would be enforceable in a bankruptcyproceeding, especially in the case where securi-ties are used. In fact, banks sometimes avoidusing cash as collateral even when it is moreeconomical because of the greater uncertainty ofretrieving the cash in the event of a default. Thegreatest uncertainty lies in the case when excesscollateral has been delivered to a counterpartywith a positive mark to market that subsequentlydefaults. If cash collateral is used to fulfill thedebtor counterparty's obligations, any claims forany "excess" cash resulting from revaluing thecontracts could be viewed as an unsecured claimby a bankruptcy court. When securities havebeen used as collateral, the excess amount seemsless likely to become an unsecured claim be-cause securities are easier to trace and to identifythan cash. Therefore, it is presumed that excesscollateral in the form of securities would beeasier to retrieve in the case of bankruptcy.

To enhance the enforceability of collateralagreements, a security agreement addendummay be attached to the customer master agree-ment. The agreements are generally customized.If all trades made between the two counterpar-ties within a particular product group are net-ted—that is, all cities, branches, subsidiaries, oraffiliates—then the collateral agreement wouldreflect this and thus avoid sending collateral toone location while receiving collateral fromanother. Similarly, cross product netting agree-ments may be considered in the collateral agree-ment. If swaps and option activity is nettedacross foreign exchange, interest rate, equity,and commodity derivative products, then mov-ing collateral for one group of products whileoffsetting values were available from anotherproduct group would be unnecessary.

To improve efficiency in the delivery andreceipt of collateral, counterparty agreementswill specify minimum increments of collateral tobe moved. In other words, rather than movecollateral daily, it would only be moved whenthe mark to market value deteriorates by a setamount (for example, $1 million). Minimumincrements save staffing costs, wire fees, andother fees. The combination of high thresholds

FEDERAL RESERVE BANK OF CHICAGO 27

and high increments can lower the cost of acollateral program while maintaining consider-able protection against large credit losses. Thisvaluable credit enhancement is attained withdaily monitoring of both mark to market andcollateral values, but infrequent movements ofcollateral.

In addition to thresholds, increments, trig-gering events, and substitution provisions, thecollateral or security agreement will generallyalso specify the types of securities, whetherhaircuts or reductions will be applied to theircurrent value, the rates of interest that will bepaid to the party posting collateral, and the timeframe within which collateral must be delivered.

Collateralizing or margining of losses in theOTC derivatives markets will undoubtedly growas a means to deal with credit concerns, unlessmultilateral clearinghouses come into promi-nence or credit concerns ease. The cost of col-lateral programs will be minimized by the costcutting methods outlined above, as well as byachieving economies of scale upon greater ac-ceptance of collateral programs. The growth ofcollateral agreements will certainly be furtheredby the trend toward standardized master agree-ments for derivatives, which will help save thecosts of completely customized agreements."

Mark to market settlement anddiscretionary cash settlement

Mark to market settlement is also used bycounterparties to reduce bilateral credit expo-sure. In this case, two counterparties agree toperiodically send cash to cover negative mark tomarkets in much the same manner that futuresexchanges require full and immediate paymentto cover losses incurred. The counterparty withthe positive mark to market takes actual owner-ship of the cash and therefore legally erases theobligations of the debtor counterparty. Unfortu-nately, this requires both parties to continuouslyagree on the value of the position, which can bedifficult for complex contracts. Also, it is morecostly to the debtor counterparty because noearnings on the transferred assets can be accruedas in collateral arrangements. In general, coun-terparties are somewhat reluctant to agree tocash settlement because the benefits of such asystem are more skewed toward the counterpartywith the positive mark to market than collateralsystems and the costs are higher to the debtor.Some master agreements now include triggeringevents which require mark to market settlement

in the case of a downgrade of the less creditwor-thy counterparty or, in some cases, either coun-terparty.

Whereas mark to market settlements requireperiodic payments on losses for ongoing con-tracts, discretionary cash settlement agreementspermit early termination of existing contracts ata predetermined settlement date. At the outsetof a 5 year contract, for example, the two coun-terparties would agree to actually settle up after2 years and terminate the contract at the discre-tion of either counterparty. If the fixed settle-ment date passes, however, without either partyexercising the settlement option, the contractmust then be held to maturity. The methodologyof marking the position to market would beagreed to at the outset. Discretionary cash settle-ment can be appealing since risk can be elimi-nated at an agreed upon date, and the cost ofperiodic mark to market payments or periodiccollateral movements can be avoided. This isparticularly useful when credit concerns for longterm contracts are particularly acute.

As mentioned above, in both mark to mar-ket settlement and cash settlement agreementsthe counterparties must clearly articulate themeans for calculating the cash settlementamount either in an appended schedule to thestandard agreement or in some other documentgoverning the relationship.

Netting services and clearinghouses

In order to aid the operational aspects ofprivate bilateral agreements, several bilateralnetting services have sprung up which provide"matching services." The two most prominentof these systems are called FXNET Ltd. andSWIFT Accord, which match outstanding trans-actions between two counterparties and replacethem with a single settlement amount at the endof the day." Both systems avoid the telecommu-nication and systems costs and the inefficienciesof matching trades in each individual back of-fice. Both systems are informational intermedi-aries and as such do not own the trades submit-ted or become involved in the settlement, whichis up to the individual participants. FXNETLtd., in operation since 1985, is owned by aconsortium of 12 of the world's top twentybanks, for which Quotron Systems Inc. is themanager. Trades entered through FXNET arebilaterally netted. SWIFT Accord is owned bythe Society for Worldwide Interbank FinancialTelecommunication, which has a financial corn-

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munications network covering 3,000 financialinstitutions in 72 countries.

Currently, there are also two notable at-tempts underway to establish multilateral nettingsystems or clearinghouses for foreign exchangeand eventually other derivatives. The creditenhancement advantages enjoyed by such ar-rangements are: 1) netting amongst severalcounterparties rather than each individuallyyields great operational efficiencies and reducespayment flows substantially; 2) the clearing-houses may provide limited guarantees to thetrades; and 3) the clearinghouses will act as acentral conduit for payments and potentiallyreduce settlement risk. These clearinghouseswill have to be approved by the host centralbank as well as meet the standards of the groupof central banks whose currencies are involved.

One of, the two attempts to establish multi-lateral netting is being organized in North Amer-ica. This clearinghouse will involve two U.S.and six Canadian banks (First National Bank ofChicago, Chase Manhattan Bank, Bank of Mont-real, Bank of Novia Scotia, Canadian ImperialBank of Commerce, National Bank of Canada,Royal Bank of Canada and Toronto DominionBank). In 1992, the members of the NorthAmerican Clearing House began using a central-ized facility to match and bilaterally net trades.In 1993, the clearinghouse is scheduled to beginproviding multilateral netting by novation offoreign exchange trades. It may eventuallyexpand to include currency option and otherderivatives. The North American clearinghousewill be counterparty to all matched trades inorder to maintain the legal discipline of nova-tion. It will net trades for settlement and mark tomarket. The clearinghouse will attempt to con-trol the daily movements of all currencies so asto create a delivery versus payment settlementsystem. Clearinghouse members will be respon-sible for covering another member's default,with the loss sharing formula based on bilateralcredit exposures, not volume. Therefore, therewill be concentration exposure, counterpartyexposure, and liquidity limits in place to controlthe risks associated with single or multiple de-faults.' 4

The other multilateral netting system underdevelopment is called the European Clearing-house Organization (ECHO) which is owned byfourteen European banks and is currently expect-ed to be operative in early 1994. Its policies and

procedures will be similar to the North Ameri-can initiative with some important exceptions.The legal basis will not be novation but "openoffer," under which any two members' tradeswill belong instantly to the clearinghouse with-out initial reference to clearinghouse limits.Over 20 currencies will be involved rather thanthe seven major currencies outlined in the NorthAmerican plan. Access to ECHO will be limitedto the SWIFT Accord trade confirmation system.ECHO will be based in the UK and therefore theBank of England will be the lead oversightorganization.15

Conclusion

Depository institutions and other derivativemarket participants have reacted to increasedcredit risk and risk sensitivities by creating inno-vative and powerful credit enhancers and bygreater utilization of credit reducing techniquesthat already existed. SPVs have the potential toalleviate credit concerns for certain classes ofmarket participants who insist on dealing withonly the highest rated entities. The successfulexperiences to date and the fact that the ratingagencies will likely ease restrictions as theybecome more comfortable with the conceptsuggest that use of SPVs will increase in thefuture. SPVs are not a panacea for credit risk,however, and therefore will likely be just onemethodology among many. Furthermore, regu-latory concerns in commercial banking concern-ing deposit insurance and risk based capital mayprevent commercial banks from establishingSPVs or may require a less capital intensiveform.

Bilateral collateral agreements have greatpotential to alleviate credit concerns, especiallyin light of the fact they do not require regulatoryor rating agency approval and thus can be usedimmediately. Although once thought to be costprohibitive, collateral users have indicated theuse of cost saving mechanisms such as thresh-olds brings down the costs to acceptable levels.The use of more standardized agreements willalso lower the cost and time involved in negoti-ating customized agreements for each individualcounterparty. Therefore, it is likely that bilateralcollateral agreements will grow rapidly in thenear future.

The increased use of bilateral netting be-tween counterparties is inevitable in the yearsahead, with or without collateral movement.Although there is much potential in the countries

FEDERAL RESERVE BANK OF CHICAGO 29

where netting is believed to be enforceable, thesuccess of the various initiatives to promoteenforceability around the world will make foreven greater potential. The increasing use ofstandardized cross product netting, especiallyacross derivative product lines, will further in-crease the potential of bilateral netting to easecredit concerns.

Multilateral netting schemes have greatcredit reducing potential for derivatives andalready have made progress in overcomingmany obstacles in their development. However,delays in launching have prevented the systemsfrom helping to ease the current wave of creditsensitivities and limited product coverage will

impede their usefulness in the near term. Whenfully operational, however, they have great po-tential for becoming one of the most importantcredit reducers of the future.

Although this article has focused on SPVs,collateralization programs, and netting schemes,it was noted that other techniques such as peri-odic settlement and close out mechanisms arecontinually being implemented. Other creditreducing techniques include guarantees, assign-ments, and private portfolio insurance. Contin-ued growth in derivatives, together with ongoingcredit quality concerns and regulatory scrutinyof these markets may be expected to give rise toeven more innovative proposals.

FOOTNOTES

'Liebowitz, (1992).

2 "Credit implications for firms that use derivatives,"Moody's Special Comment, Moody's Investors Service,November 1991, p. 2.

3 U.S. Congress (1992).

4"Moody's rates the counterparty risk of Merrill LynchDerivative Products, Inc. Aaa," Moody's Special Report,December 1991, p. 1.

'Federal Reserve Bulletin (1987).

6 Novation is defined in footnote 6 of Annex 3 of the 1988Basle Accord as "a bilateral contract between two counter-parties under which any obligation to each other to delivera given currency on a given date is automatically amalgam-ated with all other obligations for the same currency andvalue date, legally substituting one single net amount forthe previous gross obligations."

7"Report on netting schemes," Bank for InternationalSettlements, Basle, February 1989, p 12.

8U.S. Congress Financial Institutions Reform, Recovery,and Enforcement Act of 1989, Pub. L. No. 101-73, 212(a),103 Stat. 183 and 239, 1989.

9Emert (1992).

' °"Report of the Committee on Interbank Netting Schemesof the central banks of the Group of Ten Countries," Bankfor International Settlements, Basle, November 1990, p. 16.

11 "Treatment of bilateral master agreement netting underthe 1988 Basle Accord on International Convergence ofCapital Measurement and Capital Standards," Letter ofMark C. Brickell, Chairman, International Swap DealersAssociation, to Richard Farrant, Chairman, Committee onOff Balance Sheet Risk Supervision, Bank for InternationalSettlements, August 15, 1991, p. 5.

12 Wiersum and Stocchetti (1992).

13 "Banks eye forex matching systems," Wall Street Com-puter Review, Volume 9, Number 2, p. 46.

14"North American foreign exchange multilateral nettingproject status report," October 21, 1992, InternationalClearing Systems, Inc., Chicago, pp. 18-19.

15 "ECHO plans new netting scheme," Futures and OptionsPlus, Futures and Options World, Ltd., London, July 3,1992, p. 12.

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FEDERAL RESERVE BANK OF CHICAGO 31