Most banks are in the process of setting up counterparty risk management processes or improving existing ones. Unlike market risk, which can be effectively managed by individual trading desks or traders, counterparty risk is increasingly being priced and managed by a central CVA desk or risk control group since the exposure tends to span multiple asset classes and business lines. Moreover, aggregated counterparty exposure may be significantly impacted by collateral and cross-product netting agreements.
Gathering transaction and market data from potentially many trading systems, along with legal agreements and other reference data, involves significant and often underestimated data management issues. The ability to calculate credit value adjustments (CVA) and exposure metrics on the entire portfolio, incorporating all relevant risk factors, adds substantial analytical and technological challenges. Furthermore, traders and salespeople expect near real-time performance of incremental CVA pricing of new transactions. Internal counterparty risk management must also be integrated with regulatory processes.
In short, the data, technological, and operational challenges involved in implementing a counterparty risk management process can be overwhelming. This paper outlines the key challenges, starting with an overview of the main business objectives, followed by a discussion of data and technology issues, and current trends in best practices.
The objectives in setting up a counterparty risk management process can be split into three categories – CVA pricing, exposure management, and regulatory requirements. CVA is the amount banks charge their counterparties to compensate for the expected loss from default. Since both counterparties can default, the net charge should theoretically be the bilateral CVA, which includes a debt value adjustment (DVA) or gain from the bank’s own default. CVA pricing can be split into the inter-bank and corporate customer markets. New legislation, including the Dodd-Frank Bill in the U.S. and the European Market Infrastructure Regulations (EMIR), along with Basel III, are mandating or incentivising clearing and increased use of collateral over CVA as the principal means for managing counterparty risk in the inter-bank market.