(November 14, 2012) — Counterparty risk is an all-too-present danger-obvious in the ‘London Whale Losses,’ the LIBOR scandal, and the US Securities and Exchange Commission’s (SEC) revolving door of fraud cases-and it is the subject of the Commonfund Institute’s latest report.
“Counterparty risk is a fact of life, and it is unpredictable as demonstrated by sudden losses by some large financial institutions in recent years,” said David Belmont, Commonfund’s chief risk officer and author of the paper. He is responsible for all aspects of risk management for the institute. “The prevalence of fraud, uncontrolled trading losses, systems failures and control failures, when coupled with the complexity of our interconnected global financial market, makes counterparty risk difficult to anticipate and avoid,” he wrote in the paper.
Risk turns to loss swiftly in such cases, but there are things an institutional investor can do to protect the assets under their care, according to the paper. Belmont argues that best practices in this area need to start early-most of the shielding happens before anything is even signed.
Setting out a robust, explicit counterparty risk strategy is crucial, according to the author. He advises funds and investors to lay out a plan that includes the following:
• Timely, detailed and enforceable documentation detailing specific terms of any transaction
• A clear and conservative counterparty risk policy
• Minimum counterparty-acceptance and contracting standards, to clarify what transactions fall under standard securities contracts
• Real time and market driven credit-quality monitoring
• Active counterparty-exposure measurement and limits
• Frequent and timely counterparty-risk reporting, which Belmont warns is often too late in arriving to be useful
• Predefined counterparty-risk mitigation and hedging plans
“Investors and fund managers need to define their counterparty risk strategy alongside their investment strategy if they are to maximize returns,” Belmont said. “Investors and fund managers can greatly reduce their credit exposure to counterparties by negotiating contracts that anticipate the potential default of a counterparty and set out mechanisms that limit potential exposure. In negotiating such contracts, appreciation of the implications of the governing legal and regulatory regime is essential.”
An ounce of prevention may be worth a pound of cure, but occasionally that cure does come in the form of a serious windfall.
Eleven public pension funds, including the California Employees’ Retirement System and Texas Teachers’, cashed in on Bank of America’s record $2.43 billion settlement of a recent class action lawsuit. The suit, which investors filed in 2009, accused Bank of America Merrill Lynch of unlawfully covering up the acquired bank’s $15.3 billion in losses from the fourth quarter of 2008.