Section II: Mitigation of Counterparty Credit Risk
In this section, we discuss the many diverse ways of mitigating counterparty credit risk. The aim will be to highlight the mechanisms and the overall magnitude of risk reduction. However, just as important will be the assessment of the additional costs and risks that such risk mitigants will create. Counterparty risk can only be reduced and not completely eliminated. Furthermore, counterparty risk is reduced only by transformation into other financial risks, such as market, legal, operational and liquidity. It is important not to lose sight of the materiality of these risks.
The first way of mitigating counterparty risk is to reduce the credit exposure (current and/or future). The counterparty may default and the aim is to minimise the resulting loss. The most common ways of doing this are netting and collateral.
Closeout netting is a very standard risk mitigation method for counterparty risk. However, in most business relations, netting is not a significant issue. Generally, an institution either buys from or sells to another firm, but rarely does both simultaneously. Therefore, in the event of bankruptcy, few if any contracts offset one another. However, OTC derivatives markets often generate large numbers of bi-directional transactions between counterparties. Netting allows amounts owed to a counterparty to be offset with those owed by the counterparty to arrive at a net obligation or claim. Closeout permits the simultaneous ...
