Counterparty risk drives innovation

Concern over counterparty risk is driving innovative ways of managing the credit risk inherent in foreign exchange deals with corporates. Deutsche Bank is developing a whole suite of products for corporate clients that fall between clean lines and credit support annex (CSAs).

Within the industry, the issue of credit risk hasn't necessarily brought about the shake-up initially touted with centrally cleared foreign exchange forwards. In fact, according to some dealers, forwards are still being priced the same for clients that deal on CSAs, such as hedge funds, and those that trade on clean lines, such as corporates. Certainly some banks have been pricing in credit risk through credit valuation adjustment desks but this, until this past year, has been limited to trades involving, say, single B names in longer-dated transactions (FX Week, January 19).

Less than a handful of banks, including Deutsche Bank, have continued to invest in the technology capability - partly due to budget restrictions at government-funded banks - to accurately price the second order credit risk in these deals in a timely fashion. "Pricing the credit risk we take at a portfolio level is highly complex," said Zar Amrolia, global head of foreign exchange at Deutsche Bank in London. "Our modelling has to take into account not only a full set of market data, the economics of the deal at hand and the default probability of the counterparty, but also the pre-existing portfolio details, our documentation and what that means for our place in the capital structure."

Notwithstanding the pricing technology, Amrolia notes that unlimited risk is sometimes undesirable and that "there is a balance to be struck between clean lines with potentially unlimited exposure, and the kind of CSA the bank would typically have for, say, a hedge fund with initial and daily variation margin. Operationally, a CSA like that will not work for a corporate.

"We have developed a suite of products that fill this gap; providing many of the benefits of a collateral agreement in ways that suit corporate cash management processes. They can work at trade or overall portfolio level." Amrolia said so far the response has been positive.

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