Mitigating Counterparty Risk in Derivatives Trades

When XYZ had executed derivatives trades in the past, counterparty risk was not top-of-mind. Its discussions with banks typically focused on two topics: market rates and how much markup the banks would add to the market rates to compensate for XYZ’s credit risk and provide a return on capital. XYZ would typically compare the markups among its stable of swaps banks and award each trade to the lowest-cost provider.

On the surface, this approach appeared to help XYZ select the provider with the lowest price, but it had two critical flaws. First, it ignored the providers’ relative credit quality; the company treated all counterparties as equal. Over the past several years, XYZ has begun to pay more attention to the counterparty risks posed by its banks, and in deciding which bank to award its current swaps business, the company wanted to take the banks’ credit profiles into consideration as it weighed their pricing differences. Second, XYZ’s former approach to evaluating swaps providers gave the banks the opportunity to show a competitive credit markup to win the trade, with the intent of making additional profit by showing a less attractive “market rate” than might be available elsewhere in the market.