Counterparty Risk Essay

2055 words - 9 pages

Central Counterparties: New Uses for Century-Old Market Mechanisms
By: Allan D. Grody

Tammy Brown
FIN 610-9042
Dr. Dilshad Khawaja
July 31, 2011
Executive Summary
Central counterparties (CCP) have been existence since the last decades before the nineteenth century. There forms and structures have evolved over the last century but there purpose has remained the same. CCP have created an institution that essentially takes away systematic risk from a network of customers that are trying to provide products or services in an investment market. In the article I reviewed, Grody suggest that even though there is risk associated with central counterparties they rarely fail. There have ...view middle of the document...

The CCP evaluates the financial position of each party by collecting the necessary financial data of each party. Central counterparties grade each party on their overall financial position by compiling financial data. This is done to determine the overall risk associated with daily changes in credit default spreads, tier 1 ratios and market conditions through the use of business intelligence tools. If the CCP feels that they are a good match for being a viable customer the CCP will take on the risk of the transactions with other viable customers looking to make a limited risk transaction. They collect cash collateral from each party to ensure that the parties do not default on their obligations. There has been much exposure to central counterparties over the past decade due to the credit crisis of the past few years. As noted by Lewin and Todd (2010) as market confidence continued to erode during 2008, effectively managing counterparty risk emerged as one of the most important factors in stabilizing financial markets (2010, p.226). In the article Addressing Counterparty Risk, Lewin and Todd (2009) go on to define counterparty risk as the risk to each party of a contract that a party in the transaction will not live up to its contractual obligations (p.226). This is also known as default risk. They also state that all companies are vulnerable to this type of systematic risk. Corporations have turned to central counterparties (CCP) to help mitigate the risk associated with doing business with parties that may have extended risk factors. Due to the global climate of business dealings that prevail today, this risk may not be as evident with parties that are located in other parts of the world. CCP act as clearing houses for a network of businesses that are sometimes in different markets or industries.
Clearing houses were created in the last decade of the nineteenth century. They were formed so that multilateral transactions were secured through payment and settlement associations. Back then items such as grains or live stock were used as a source of collateral. Clearing houses reduced the risk that one party would not live up to their contractual obligations. The risk of default was no longer with the separate business parties but the risk shifted to the clearing house. Most derivatives today are traded through the means of a clearinghouse.
A clearinghouse interposes itself as the counterparty of record for all transactions. In so doing, the CCP protects trading participants from both settlement risk and replacement cost losses arising from a counterparty default. Their purpose is to minimize the amount of risk a corporation may have if one of their essential suppliers is unable to provide them with the necessary products or services in order for production to continue. For example, many manufacturing plants have several suppliers for items such as electrical components, processors, and other raw materials. If corporations...

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