Executing the Trade: Controlling the Risk
by Peter Seward, Vice President of Product Strategy, Reval
When executing a derivative trade, there are two major considerations a company needs to think about: who they choose as their bank counterparty and how they are satisfying their internal policies regarding derivative trading. The current market environment for corporates entering into derivative hedging transactions is one of uncertainty — not only about the fluctuation in interest rates, currencies and commodity prices, but also about the creditworthiness of banks and even sovereign states. Add to that uncertainty about the regulatory environment, and the external factors for determining which banks to trade derivatives with becomes even more important. Internally, companies must comply with board policies and regulatory requirements, such as Sarbanes-Oxley and the forthcoming rules from OTC derivative reform. When executing a derivative trade, then, only the right system functionality and related processes will enable a company to effectively recognise and respond to changes in the external environment, while ensuring compliance with internal requirements.When a company enters into a relationship with a bank, it is usually for multiple services, such as short- and long-term financing, brokerage, capital markets, payments, cash management, etc. However, when deciding which bank to deal with for derivative trades, the factors that are most important to consider are:
- Credit rating
- Credit lines
- Current and potential exposure with the bank
- Additional services
When executing a derivitive trade, only the right system functionality and related processes will enable a company to effectively recognise and respond to changes in the external environment, while ensuring compliance with internal requirements.
Before the credit crisis, corporates could concentrate on a few of these (e.g., price, relationship) and ignore the rest without concern. These days, however, timely information on all these factors is critical. By automating the life cycle of the derivative transaction, corporate treasurers, their back offices and treasury accountants can obtain this important information quickly and in a way that provides a valuable audit trail, a structured process for approval and overrides, and a straight-through processing environment for eliminating manual errors.
Internal factors relate mainly to the specific controls and limits usually written into risk management policies to ensure compliance with board and regulatory requirements. Such requirements result in policies and procedures that traders need to follow to ensure that only approved instruments are traded and only for approved business purposes. These include:
- Trader limits
- Daily settlement limits
- Trade type approval
Let’s take a closer look at what a company needs when considering these external and internal factors and how technology can make it easier to execute a derivative trade once pre-hedge analysis has been completed and before post-trade processing begins:
What to consider
Board directives usually require corporates to deal only with banks with a minimum credit rating (e.g., A+, AA or better) as they know that no price is good enough to outweigh a bad credit rating. Corporates need immediate access to the credit rating (short- and long-term) of any bank they are considering dealing with. Additionally, they ought to know if the bank is on a credit watch. These days, knowing the domicile of a bank is also useful, as sovereign risk is an extra factor in some parts of the world and needs to be considered. Trading with a bank domiciled in a country where sovereign risk is greater than individual bank risk really means that the bank risk is at least equal to the sovereign risk.
A system should be able to store a company’s minimum credit rating requirement and the current credit rating of a prospective bank. It should only permit trading with banks that meet or exceed the minimum requirement. A useful complement to ratings is the directional indication of short- and long-term credit spreads. This helps to avoid the frequent complaint that rating agency information is backward-looking and not anticipatory. If a corporate has access to CDS spreads for bank counterparties, simple statistical measures can be calculated. Also required is a means of attaching a quantifiable limit, either as part of an overall credit tier or individually at the bank level. The limit may be further classified by trade type or derivative type and tenor (short- or long-term). A company should then have the ability to check the amount of an intended trade against the available limit.