Are counterparties exactly who you think they are?

The past week’s financial pages have been full of stories related to counter party risk.  It has been reported that following Lehman’s bankruptcy recoveries for unsecured creditors might be as low as 11 cents on the dollar, whilst meetings have taken place to address the ‘netting out’ of offsetting positions that Lehman held with numerous counter parties.

The problem underlying the rubble of Lehman’s collapse is that many of these trades, the result of over-the-counter (OTC) transactions, have no overall guarantor, with trading parties simply acting with the expectation that the other trading party was suitably creditworthy and able to honor any losses.

In OTC markets the lack of a clearing house to act as an intermediary and make sure that each side of the transaction performs its contractual obligations means that trades are negotiated directly between traders, broker dealers and fund managers who assume the levels of each others credit risk.

This adds a second area of complexity to the Lehman story – that trading counterparties cannot be sure exactly which legal entity of an organization they have been trading with until they have received the trade confirmation.  It is common, for example, for a trade to be done with the London office of an investment bank but the confirmation to come from somewhere entirely different.

The best case scenario is that the trade is confirmed by a local branch owned by the parent company that has the parent company balance sheet and its credit rating association – but it might not!  There is exposure between the time of the trade taking place and the receipt of confirmation.  How can you efficiently manage your risk if you don’t know explicitly who you’ve done trades with?

While facilitating accurate and timely record-keeping, the affirmation on trades on trade date (Same Day Affirmation – SDA), addresses such gaps in the effectiveness of risk management initiatives across all areas of the trading cycle.  If the current market conditions are testament to anything it’s that a lack of appreciation for risk – such as a slow trade confirmation process – can have a dramatically impact in times of difficulty.

The OTC and equities markets are two sides of the same coin.  The derivatives markets have clearly been flavour of the month with industry commentators but there is also still a long way to go before confirmation and affirmation rates are higher in the equity markets.  Same day affirmation is beneficial for all asset classes, traditional or not.  Regulators should accelerate their decision making process and focus on practical steps that can achieve higher operational stability and SDA is one step towards this.