November 15, 2010

Question: When is a bank run not a bank run? When it’s a bank run, of course! For anyone who enjoys irony, the story last weekend about Spanish Bank BBVA’s sponsorship of a local 10k race is pure delight. As race entrants began to form lines outside one of the bank’s Madrid branches to pick up their race packets, observers took note that something was not quite right with the 2nd largest bank in Spain. Word filtered back to traders, and the stock began to tick lower, with market participants fearing a liquidity crisis in the making.

Were depositors lining up to withdraw their savings? BBVA was thought to be a strong institution, and only days earlier had announced a 5.1 billion euro rights offering (right for shareholders to buy additional discounted stock) and announced the purchase of a 24.9% stake in Turkish Garanti Bank, which would diversify BBVA’s holdings away from the slumping Spanish economy. It took the media and traders a few hours to figure out that the lines were filled with race runners, not bank runners, and everyone had a good laugh and the stock recovered. Non-existent crisis averted, and all involved could sleep tight once again.

But what does this story say about the state of counterparty risk? Two years after Lehman Brothers collapsed, and with more than 300 US banks closed by regulators in the same span, market participants can be forgiven for feeling a bit “jumpy” at times. The speculation about the healthy BBVA nonetheless seemed entirely plausible, given that a long line had formed (must be depositors, demanding their money!) outside a Spanish Bank (they’re woefully undercapitalized, right?) in mainland Europe (Sovereign Debt Crisis!). Even though the global banking sector has set a course for recovery, and Basel III reforms should increase stability with higher capital standards, a bank is still only as strong as its bond with investors, borrowers, depositors, and trading partners. With uncertainty about the economy and the health of your trading partners as a backdrop, a robust counterparty management plan is still essential when dealing with your derivative transactions. The following “3Ds of Counterparty Management” can help you manage your risk and set the best plan in place for your business.

Diversification. If you have a single interest rate cap or swap in connection with a loan, then diversification need not apply. But if you require multiple derivative positions to manage your interest rate, currency, or commodity risks, then having a number of trading partners is not just good for best execution and pricing, it is essential for managing your exposure to any one counterparty. With every new trade, you have the opportunity to incorporate new information, re-assess the risks, and trade with or auction among the strongest in the pool. A new trade is also the perfect vehicle by which to cross-level exposures, or allocate according to internal policy limits. A diverse set of counterparties will also allow you to compare credit terms, and weigh singular demands such as independent amounts, mutual credit puts, or credit charges against all other economic factors in a deal. Ultimately, a pool of several trading partners may well be the best way to reduce counterparty risk in your growing portfolio of derivative transactions.

Documentation. The ISDA Master Agreement, with negotiated Schedule and Credit Support Annex (when applicable), are still your first line of defense when it comes to managing your counterparty relationships. The Schedule modifies the agreement by making provisions bilateral or unilateral, by expanding or narrowing the meaning of important definitions, and by scoping in or scoping out affiliates and other agreements. A fully executed ISDA grants certain rights and remedies to a party when an Event of Default or Termination Event is triggered, and provides for the orderly unwind, closeout, and setoff of all trades under a single agreement. When negotiating an ISDA, you will need to balance protections for your business against the costs of executing trades under the agreement. As you negotiate with other counterparties you will get a better sense of whether your protections and costs are satisfactory and “at market” relative to other agreements. At the end of the day, familiarity with the provisions in your ISDAs will help you differentiate among your pool of counterparties to your benefit, and will best protect your interests in the event that a counterparty is stricken by the credit crisis.

Dodd-Frank. The recently passed Dodd Frank legislation creates new entity classifications and applies certain rules to each that have major implications for counterparty risk. In simplest terms, the law states that entities that are “financial entities” will be required to centrally clear certain trades. A financial entity is defined as a swap dealer, major swap participant, commodity pool, private fund (including hedge funds, real estate funds and private equity funds), employee benefit plan, or firm that is predominantly engaged in activities that are financial in nature (including banks, insurance companies, mortgage REITs, and many others). Trades that are centrally cleared would be subject to margining requirements that will fully collateralize the positions on a daily basis. Counterparty risk is almost entirely removed, as both parties to a trade no longer face each other directly but would instead be facing the exchange or clearing house under these scenarios. Any firm that is not a “financial entity” is exempted from the central clearing requirement under most conditions. This hard fought exemption actually now provides a choice. For those non-financial firms that would want to clear trades under the new law, especially public companies, a clearing agreement can be entered into with one of the clearing house members, and trades can be centrally cleared. For the vast majority of non-financial entities that want to continue to use their property or business as collateral for their derivative transactions, your trades can continue to be governed by your negotiated ISDA agreements. Now that Dodd-Frank is law, it will be best to learn how specific provisions apply and can help you mitigate your counterparty risk.

If you have questions about your counterparties, give us a call! Chatham regularly helps clients diversify their trading relationships by adding counterparties and negotiating the best ISDA terms with each. We can help you value and manage your counterparty risks, and have tools to help manage and track collateral. Chatham also has a team that is 100% focused on navigating the changing regulatory landscape and assessing the impact of the Dodd-Frank Derivatives Title on your business. We would love to help you with any counterparty questions or needs.