Counterparty and liquidity risks in Treasury - KPMG Sverige
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Counterparty and liquidity risks in Treasury – two sides of the same coin

Counterparty and liquidity risks in Treasury

Depending on the contracts’ structure, liquidity risks arise from cash-secured contracts in the case of futures and CSAs, or counterparty risks in the case of unsecured contracts.

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The management of the market price risks of currencies, interest rates and commodities with derivative financial instruments, inevitably also entails counterparty and liquidity risks. The strategic and operational management of this overall risk exposure will bring its own challenges (and possible solutions) for the Treasury of the future.

Dekorbild: Counterparty and liquidity risks in Treasury – two sides of the same coin

Management of market price risk as a source of counterparty and liquidity risks

For most Treasury departments in large international groups and medium-sized companies, the management of market price risks from interest rate, currency and commodity markets is an important task. These risks are typically hedged using derivative financial instruments such as (interest rate) currency swaps, FX options, commodity futures, etc. Over time, these instruments are revalued with either a positive or a negative market value.

Depending on the contracts’ structure, liquidity risks arise from cash-secured contracts in the case of futures and CSAs, or counterparty risks in the case of unsecured contracts.

Dekorbild: Management of market price risk as a source of counterparty and liquidity risks

As the graph shows, counterparty risk, market price risk and exchange rate risk as well as liquidity risk arising from margin agreements or other collateral requirements are directly related to each other. Hence, if the market price risk is managed using derivatives, as most companies do, this inevitably entails counterparty risk and/or liquidity risk. Group-wide risk management must therefore use an integrated approach to balance and manage these risks. In view of the limited resources available to cover these risks (e.g. extent of risk-bearing capacity, availability of liquidity), a management decision must be made as to how much overall risk is acceptable for the company, how the risk capital should be allocated to the individual risk types and which risk strategy should be applied to the individual risk types. When deciding on how to design risk management functions and methods, the importance of each risk and the interdependencies between them must be taken into account and assessed.

Integrated risk management in Treasury's day-to-day operations

The joint management of the three risk types should be based on an integrated approach which first defines the associated risk strategy at Group level and then defines the overall risk-bearing capacity and the distribution of the individual risk types.

Depending on the company’s individual situation, the risk assessment and thus also the resulting strategic structure of treasury management can vary greatly.

If, for example, the company's market price risk is negligible compared to its sales and profitability, it suffices to monitor this assessment at regular intervals using scenario analyses of future market prices and their ability to be passed on to customers.

In the current interest rate environment, liquidity risk is often not that significant due to high cash holdings, or the margin risk is negligible in relation to the liquidity risk arising from the operating business. A suitable strategy may then be to fully bear the liquidity risk in favor of eliminating market price and counterparty risk. Operationally, this would mean concluding CSAs for a large number of OTC transactions and collateralizing them with cash collateral.

If, on the other hand, a company has low cash reserves and high financing costs or tight covenants in financing contracts, its strategic considerations will be based on different premises. In such a situation, the choice must be either to bear a certain portion of the market price risk or to exchange the undesirable liquidity risk for a higher counterparty risk by concluding unsecured OTC transactions.

These strategic decisions should be based on the fundamental premises of risk-bearing capacity and sound modeling with scenario analyses for the individual risk types’ risk level. When building the model, in addition to taking into account current and future exposure levels, market price volatility and changes in creditworthiness, the modeling process must also take into account other macroeconomic factors. The great advantage of considering counterparty risks and liquidity risks together lies in the synergies for the modeling and the implementation of the model for both risk types. This is due to the fact that for both risk types assumptions about future market price developments must be made and appropriately mapped. This applies on the one hand to the actual modeling of the risk measures, but also to the related scenario analyses, which can be covered with a common tool set.

Particularly when analyzing liquidity risks, liquidity risks arising from operations should not be neglected thus allowing for a sound overall view of the Group-wide liquidity risk. At present, models using AI and mass data, for example from the ERP system, are increasingly being used, which can significantly improve the quality of both forecasting and risk measurement.

The latest models for assessing market price risk, liquidity risk and counterparty risk are very similar in their methodology and IT implementation, and are based on proven quantitative models. The risk levels strongly correlate to the data sets required (i.e. information on current exposures, mark-to-market, counterparties, internal and external ratings, market prices, volatilities, etc.) and the models used. Regarding the employees needed to identify, analyze, measure and manage these risks, one would want an integrated team of risk management specialists to achieve maximum synergies and to enable smooth operations.

In addition to performing an initial scenario analysis and defining the risk strategy, it is recommended to standardize and automate these models and analyses, which are then transformed into a rule-based process on a monthly or quarterly basis.

From accounting to integrated credit risk management

When recognizing financial instruments in the balance sheet in accordance with IFRS 9 and 13, credit risk must also be taken into account. The calculation of the credit valuation adjustments for all financial instruments measured at fair value, including electricity and gas supply contracts that do not meet the "own use exemption" criteria and the measurement of expected credit losses for financial assets not measured at fair value (including exposures) are based on credit risk models. In the past, many companies limited their treatment of credit risk arising from derivative financial instruments to covering the (minimum) measurement requirements of IFRS 13 in order to determine the fair value. The same applied to their meeting the requirements for the impairment of credit-impaired financial assets in accordance with IFRS 9. In view of an integrated risk management and the liquidity risks to be considered simultaneously, it now becomes apparent that the models are by no means solely necessary for the purposes of the financial statements, but that with a little additional effort, they can also manage operational credit risk, thus generating real added value.

Conclusion

In recent months and years, many companies have started to scrutinize counterparty risk more closely, primarily as a result of the accounting standards IFRS 9 and IFRS 13. At the same time, because liquidity management methods have been automated, they have also significantly improved. Now that companies are largely up to speed, in a next step they should focus on managing both risk types, which offer a great deal of synergy potential due to methodological similarities, by bringing them together both from an operations and an IT approach and dealing with them in a strategy covering both aspects. This can significantly contribute to the improvement of risk capital allocation and the better allocation of risk and liquidity costs to business activities.

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