Fundamentals of Trading and Credit Risk

What happens in trading to credit credit risk and how can this risk be managed?

What is OTC and Exchange Trading?

What is trading on an exchange?

Before we discuss trading, we need to define an exchange.

An exchange is:

  • A central system where buyers and sellers issue their buy and sell orders
  • The exchange system matches orders between buyers and sellers
  • The exchange commits each buyer and seller to a trade, which it communicates to both parties
  • Now largely electronic, very few open outcry (human shouting) exchanges exist now

Examples of exchanges are:

  • The London Stock Exchange
  • The New York Stock Exchange
  • CME
  • ICE
  • The Tokyo Stock Exchange

Trading on an exchange

A buyer must either be a direct member of the exchange or be represented via a broker. Each transaction starts with an order to buy or sell, and sometimes with a limit on how high or low the price must be to fulfill the order.

  • e.g. Buy 10 shares in IBM provided the price is no higher than $100

The exchange system will find a seller who can meet your order criteria both in size and price, and then connects the two parties into a trade with a fixed price to be settled at.

After the trade is executed it is immediately transferred into a Clearing House which handles all the settlement activity for the life of the trade.

All buyers and sellers are subject to the rules of the exchange and in most cases access the platform electronically from their own offices. In the past exchanges involved 

 

What is trading OTC?

Trading Over The Counter (OTC)

In contrast to an exchange, the OTC method of trading involves both parties communicating directly by various means to establish the terms of a trade.  Methods of trading can include:

  • Voice - direct to counterparties
  • Broker - either electronic or voice
  • Organised Trading Facility (OTF)

In each case negotiation of the terms of the trade is made without a central system, in some cases brokers and an OTF can intermediate on price.

Once the terms to a trade are agreed some form of Confirmation must be made to ensure that both parties agree on the specific terms of the trade.  Following confirmation the trade will be processed in the back office of each party, or also sent to a central clearing house.

What is credit risk?

Credit Risk is a debt from one party to another, arising from the promise to pay in the future. If I borrow $10 from you now and promise to pay back in one year, you then have a credit risk on me for $10 for a year, until I repay.

Before the modern capital markets, the simplest form of banking was loans. Banks lent money, and only as much as they felt you were able to sensibly repay. Each bank would record the loans against each customer, and decide the total amount of borrowing you could have.

You might borrow three times but the total amount borrowed from one bank won't go over the total limit they set for you or your firm.  This maximum amount is a <credit limit>, which needs to be set, monitored and re-set as circumstances change.

Credit Risk From a Rate Swap

Take a detour and learn about <interest rate swaps> if you need to, then come back here.

A typical <interest rate swap> has a duration of 10 years, this is the most frequently traded duration. The two parties to the swap agree to pay a stream of cashflows to each other over the life of the swap. 

  • On a fixed leg, the stream of cashflows is known and can be easily summed to one amount.
  • On the floating leg, the cashflows are only known once the relevant calculations are made in each payment period.

The credit risk on an IRS isn't as simple as that of a loan, due to the unknown payments on the floating leg.

EXAMPLE CREDIT RISK SCENARIOS

Valuations or Mark to Market

In which case the entire swap transaction has to be valued (or marked to market) to arrive at a single figure, which represents the net value owing from one party to the other.

  • A positive valuation means your firm is 'in the money' and is in theory owed that amount from your counterparty
  • A negative valuation means your firm is 'out of the money' and owes the other party

Unfortunately, this valuation only represents a single point in time, at which the many market values used to perform the valuation were taken. Market values move during each day and move in the long term.

Finding the credit risk on a swap over it's life can involve multiple simulations of the market conditions to explore by how much that swap could make or lose money over it's life. This approach becomes statistical and is sometimes referred to as Value at Risk. Learn more about Value at Risk (VaR) in relation to <initial margin>.

Terms and Links

Terms used in this section:

  • Interest Rate Swap
  • Floating Leg
  • Credit Limit
  • Valuation / Mark to Market
  • Initial Margin

More information

https://en.wikipedia.org/wiki/Credit_risk

https://en.wikipedia.org/wiki/Credit_limit

etc

How does credit risk occur in other products you know about?

How does clearing work?

A Central Clearing House or Central Counterparty (CCP) transforms credit risk between parties, enabling them to do more business.

Outside of clearing, each party must measure and manage the risk of default by the other, and use collateral management to transform that risk internally.

A clearing house takes on the role of risk transformation and management on behalf of users. The original credit risk is transformed by various means:

  • Variation margin to capture the end of day valuation
  • Initial margin to capture the long term risk of the entire portfolio
  • Default fund to manage the risk of clearing house members becoming bankrupt
  • And underneath this holds cash and securities which themselves need managing to avoid concentration and liquidity risk

CCP Overview

After the trade is executed at an exchange or OTC, the trade is sent to the CCP as a single trade between the two original parties. The CCP uses a legal process to interpose itself between both parties and become the counterparty to each.

From then on, the CCP rules apply, amongst other things each party must:

  • Pay or receive variation margin
  • Pay initial margin
  • Pay their Default (Guarantee) Fund contribution
  • Settle coupons on swaps or option premiums
  • Take part in Default Management practise sessions

CCP In Control

The CCP has a governance structure which members take part in. The CCP takes the primary role in designing the methods by which:

  • Trades are valued at the end of each, and sometimes during the business day
  • How Initial Margin is calculated
  • How the Default Fund is calculated

It is also a self-evident truth that if either party fails to meet any of the obligations to the CCP, the CCP can place that party in default, close down all its trades, and remove them from the clearing house.

Why are trades sent to clearing?

  • Regulators
    require certain classes of OTC products to be cleared
  • Exchanges
    always send trades to clearing
  • Parties
    send trades voluntarily to get the benefits of clearing

There is only one clearing house for OTC products?

  • No, there are multiple CCPs for clearing OTC products
  • Yes, OTC products are cleared at just one CCP in the world