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II. Credit Risk Management
Strategies For Credit Enhancement
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Participants draw on a variety of credit enhancement strategies to reduce the credit risk associated with one or both parties in a derivatives transaction. These strategies tend to follow one of two approaches. The first approach is to reduce the probability of default. The most common strategies taken under this approach are third-party letters of credit and guarantees to enhance creditworthiness. Some derivatives dealers have recently enhanced their credit ratings by establishing special purpose vehicles (SPV) or special operating subsidiaries with a credit rating that is higher than that of the parent. The second approach is to reduce the exposure on the underlying transactions. The most common example of this approach is the collateral arrangement whereby one party (or both) periodically posts collateral based on the mark-to-market exposure on the underlying transaction(s).
As derivatives activity evolves, participants will continue to develop new strategies to manage and reduce credit risk. The new strategies will be market-driven solutions to the problems facing participants. Some participants will seek new ways to bolster their creditworthiness with capital-based structures, while others will pursue solutions that are based less on capital and more on limiting exposure on a periodic basis through such devices as collateral arrangements. Under either approach, increased netting arrangements that are legally enforceable will play a major role in reducing credit risk throughout derivatives markets. Multilateral netting arrangements potentially could reduce the exposure further, but raise other issues regarding systemic risk.
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II. Credit Risk Management
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