50 Shades of Counterparty Risk

What follows isn’t going be quite as racy as the books (I hear) from which I paraphrase the title for this essay. However I will be offering up some suggestions to help you not get tied up by your counterparties. At times many people in the industry, myself included, tend to only view counterparty risk as some cataclysmic event like 2008. Markets in turmoil, banks failing or on the brink and a general global crisis. But the absence of such an environment or market condition does not mean an absence of counterparty risk – just an absence of that particular kind of counterparty risk.

[1] There are many types of events along the continuum of counterparty risks that need to be acknowledged and managed in a dynamic manner. Perhaps we should start with a definition of counterparty risk: A material business disruption event brought about by the actions of one or more of your financing/custody providers. Now obviously Lehman fits this definition but so do many other more localized, hedge fund specific events. Here are some different types of counterparty risks along the continuum to consider:

  • Access to Assets – This comes in two flavors:  Lehman Brothers where one or more of your primes goes bankrupt or what happened in 2008 with Morgan Stanley where your counterparty is experiencing significant financial difficulty which results in the restriction and delay of asset transfers.
  • Information Security – The control environment (or lack thereof) at your counterparties for safeguarding your confidential information.
  • Operations – Process issues at the counterparty can result in material losses or result in transaction delays (e.g., cash transfers failing which can create risk at another counterparty by not meeting a margin call).
  • Technology – Sub-standard information systems that result in service interruptions that make it difficult to run your business.
  • Business Continuity (BCP) – Included here is the possibility of one or more of your counterparties “going dark” due to cyber-terrorism.  Also the adequacy of your counterparty’s BCP for other types of events (e.g. weather) should be evaluated.
  • Legal – Legal agreement terms that give your counterparty rights that can cause you significant hardship during times when your financing provider or your fund is experiencing financial difficulty.
  • Profitability – Your counterparty decides to terminate your Prime Broker relationship because your revenue or return on assets (ROA) is too low.

It is important to have a comprehensive counterparty risk management process that covers exposure management, crisis preparedness, due diligence and training. A sound plan will enable hedge funds to mitigate any of the aforementioned risks with their counterparties. It’s always good to have the key for those handcuffs.   [1] And in these times of advanced government regulation the banks probably are safer, though we weren’t too worried in 2006, you still need to monitor insolvency risk.

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