Closeout Risk and Exchange Traded Options

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The measurement of counterparty risk for most investment banks is based around Over The Counter instruments, these are derivatives or structured contracts that are sold to the client directly. Banks also take positions through exchanges on behalf of their counterparties and they do this for several reasons:

• Speed of execution
• The ability to transact through one bank account rather than opening another account on the exchange
• Advisory before deal transaction
• The ability to ”hypothecate” or assign available collateral and cash in custody with the bank against exchanged traded positions

Stock exchanges, clearing houses and futures markets keep excess exposure to a minimum and they do this through the process of daily variation margining. However, banks trading on behalf of counterparties, also become responsible for taking care of these margin requirements. In effect, they also need to monitor market volatility to ensure that there isn’t a loss due to close out risk.

What is close out risk?
Trades are often entered in the name of the bank consequently the bank will inherit the responsibility to close out defaulting open positions.  This event may occur from a counterparty being unable to pay or cover a margin call with collateral.  Given various time zones around the world, this exposure can extend out to a T+3 trading window on a bad day.  

"In a normal trading environment this isn’t of much concern however during the credit crisis, market volatility was so high that many banks struggled to effectively clear margin calls and consequently became the “guarantor” for the depth of positions they had executed on behalf of their counterparties."

Moving to a better place
Believe it or not, some banks are margining these exposures on spreadsheets. One specific project I ran, involved bringing this informal practice to an end and quite abruptly I might add.   The goal was to develop a solution in twenty four days that could allow the dark ages of margining in Excel to be replaced with a new system and standard risk management practices in the bank.  The focus of the project started with exchange traded options clients were holding through the bank and involved tracking of price changes against margin head room movements that might occur from daily price volatility.

The system that was developed, included a full registration of counterparty static, a connection feed from the exchange, overlaying of facility limits, an internal exposure calculator and a final report that could be used by credit staff to monitor netted position taking in their options book and for each counterparty individually.

A short write up on how this project was approached can be found here.