Counterparty risk now firmly on the agenda

The collapse of Lehman Brothers last September made both private investors and distributors of investment products suddenly more aware of counterparty risk.

“For the first time ever, private investors now realise that there is such a thing as counterparty risk,” says Lea Blinoff, managing director at HSBC private bank’s wealth management and investment division. “Before Lehman collapsed, counterparty risk was not really perceived to be profound, as it was just unimaginable that a major investment bank would go bust.”

In structured products, counterparty risk is borne by the investors and refers to the risk of the underlying issuer of the financial instruments which back the structured investment defaulting on its obligations. Hence, factors that influence the issuer’s credit quality have come under scrutiny. In the past, private investors tended to favour those providers which offered cheaper fees, says Ms Blinoff, but they are now more willing to take the time to discuss in great detail the factors that may affect the price and the quality of the counterparty.

“Pricing is still an important factor in determining best execution,” she says “but private clients, and the industry in general, have had a stark lesson that counterparty risk is real, and needs to be factored into the pricing of these instruments.”

Credit ratings are a recognised indicator of the financial strength of an institution and a measure of default risk. “It is easy to point to all the failures or errors of the rating agencies,” says Ms Blinoff, “but independent credit ratings provided by professional rating agencies remain very valid, although they cannot be, and should have never been, the single source of information to form a view,” she says.

Investors now understand better the implications of the risk-reward trade-off of the counterparty. “The cash remuneration paid by a bank having a high credit rating is less attractive than that offered by a bank having a lower credit rating, but risk is lower too,” explains Emmanuel Naïm, head of equity structured products at Société Générale Corporate & Investment Banking. But while before the financial crisis, the strong French provider would find itself to compete with banks which, having a lower credit rating, offered better prices, Lehman Brothers’ bankruptcy “has changed the rules of the game,” says Mr Naïm.

“Investors are no longer indifferent to who is issuing the product. There has been a flight to quality, in particular towards structured product issuers that are universal banks.” The typical Anglo-Saxon business model of investment bank has suffered greatly, he says. “Clients rely more on much diversified kinds of banks, which have diversified business models.”

Société Générale is a big player in the universal banking world, says Mr Naïm, as it is built on three different streams of business – the retail bank, the investment banking and the asset management – which have different sources of money generation.

Damaged reputations

Distributors of structured products suffered huge reputational damage from Lehman Brothers’ bankruptcy, particularly in Germany, says Kemal Bagci, structured products specialist at DWS. Many banks used to sell certificates issued by third-party investment banks branded with the distributor’s own name, in white-labelling fashion, but this no longer happens. Increased focus on transparency, which has become the mantra for the whole financial industry, has driven distributors to state clearly the issuer’s name on their product brochure.

Due diligence has increased remarkably, notes Mr Bagci. Credit ratings from top agencies such as Standard & Poor’s, Moody’s and Fitch Ratings are now widely used in combination with credit default swap (CDS) spreads, which measure how much the market is willing to sell insurance against default for the issuer. Moreover, certificates rating agencies have grown in popularity in Germany, he explains. These agencies carry out analysis of the credit spread, evaluate the fairness of pricing and are able to give an overall grade to the certificate.

A trend that has clearly emerged is that distributors now tend to use more their in-house structured product providers, although some saving banks are focussing more on diversification, he says. “A key rule to reduce your exposure to credit risk is to diversify your structured product providers,” he says.

But diversification may prove slightly more challenging than in the past, as the number of investment banks has shrunk. Moreover, with the exception of few firms, top players stepped back from their very large and aggressive, proprietary trading issuance, especially in the aftermath of Lehman’s collapse, says Ms Blinoff at HSBC.

Today, the situation has improved. “Issuance volume and trading levels have improved enormously from the dark days and extreme risk aversion that we saw back in the autumn last year and in March this year,” she says.

At HSBC private bank, structured product providers are chosen amongst the recommended list of approved counterparties. The final selection of counterparties is made on providers’ specific skills. “We use both HSBC and external counterparties as we have always done in the past,” says Ms Blinoff. “This is important because no one firm is market leader in every asset class.”

The robustness of UBS’ proprietary framework which, through both qualitative and quantitative measures identifies and monitors a list of eligible counterparties, has been increased in the wake of recent events, explains Peter Ham, head of the transaction products group at UBS Wealth Management in the UK. “Our eligible counterparties are not only selected on quantitative criteria,” says Mr Ham. “We have always looked, and look even more now, for service quality and qualitative issues.”

The emphasis is placed on those service providers that can maintain orderly prices during distressed periods, and that understand the needs of private banks and their clients, he says. “Private clients have made it very clear that they want a lack of complexity, transparency in terms of pricing, in terms of secondary market and liquidity.”

While the list of eligible counterparties is always evolving, it is now a more stringent list, says Mr Ham, and the criteria have been refined and more robust.

Providers who cannot really benefit from economies of scale will find it very difficult to play a role in the market, says Uwe Becker, managing director, investor solutions, at Europe Barclays Capital. There is growing pressure on providers to build up infrastructure around the provision of structured products, to ensure minimisation of production costs, to meet client demand for a broader product range and for liquidity in the secondary market. Bigger players with a bigger platform or more robust and efficient infrastructure will benefit from it, he says.

However this is not going to lead to a scenario where a few large firms will dominate the market and have stronger pricing power, believes Mr Becker. Indeed, it is quite the opposite. Both Mifid regulation, which imposes more transparency in pricing in the industry, and increased competition at the top of the league table are putting a downward pressure on structured products’ fees, says Mr Becker.

Increased efficiency allows providers to offer to private and retail investors very competitive prices, which are similar to those provided to institutional investors. “The business around listed standard products is very much industrialised nowadays,” he says.

Meeting client demand for safety

To address investors’ growing concerns over counterparty risk, a number of providers have launched products where they use highly rated assets to secure the capital protection or they collateralise counterparty exposure or use a combination of the two.

Last October, DWS decided to collateralise some certificates which the firm issues out of its specialised purpose vehicle in Luxembourg, which was set up in 2006. Because this vehicle has special rating agreements with its swap providers and is made of different segregated compartments, each one of them responsible for different certificate issues, the vehicle itself is a safer option, explains Mr Bagci at DWS.

The collateralisation against the risk that the swap counterparties, in DWS’ case mainly Société Générale, may default, is implemented with G10 bonds, ie bonds issued by the largest industrial economies in the world.

“Back in October, we had some strong demand when the market was at the brink of collapsing, we were still selling a lot of products on that collateralised platform,” he says. “But now people have come back to be more price sensitive again and we see a lot less demand now.”

Confidence is coming back into the market, there is more trust that the governments are supporting the financial system and investors are looking for opportunities in the increased risk premia the market requires, says Mr Bagci.

Last year, Société Générale also set up a Luxembourg company, Codeis, which issues secure notes under its own name. The proceeds of the subscription are invested into a collateral, which is selected by the end client, explains Mr Naïm, so that the credit risk is really tailored to the client’s needs. “We have seen some interest in these notes, but since most investors are confortable with SG’s brand, the majority of issuances remain under the bank’s name,” he says.

Demand “has been mild” for Barclays Capital’s investment solutions which mitigate the bank’s credit risk, confirms Mr Becker.

“The reason why demand in general for this kind of safer products or products wrappers is not as great as many people anticipated is that the cost for collateral is enormous,” he says.

Especially in an environment of low interest rates, this additional cost reduces the attractiveness of a collateralised product significantly, he says.

Counterparty risk is especially relevant for the more investment-type products, the buy and hold products.

“The longer the maturity the more dominant is the factor of issuer credit risk in the eyes of the investors,” says Mr Becker. That counterparty risk does not play a major role for bonds, mini-futures and exchange traded notes is highlighted by the fact that for example in the retail German market, the exchange turnover of the short-term trading products has actually increased lately.

“When the investors have a very short investment horizon, a couple of days, or hours, they are not that concerned with the issuer credit risk as opposed to when they invest in a product that they intend to hold for years,” he explains.

Indeed, one of the effects of the increased awareness of counterparty risk is that, in general, in the whole industry, the average maturity of the buy and hold investment products has been reducing.

“Whereas four or five years ago it was not really difficult to place a structured product with a six-seven year maturity, we find it more difficult to do that today,” says Mr Becker. “People typically now invest on a two-three year investment horizon.”

Investors’ greater demand for shorter maturities is also due to the considerable uncertainty over the future direction of equity markets.

Today’s increased focus on counterparty risk is not just a short-lived effect of the Lehman’s case, believes Mr Becker. “Issuer credit risk will always play an important role in the future when an investment decision is being made.”