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Account for the way special purpose vehicles (SPVs) come into play in OTC derivatives dealings.

FRM® Part I · Financial Markets and Products · Exchanges and OTC Markets · FRM1.FM.5.i

The idea

A special purpose vehicle (SPV) is a separate legal entity whose assets and liabilities are ring-fenced from its sponsor, so it is bankruptcy-remote. In OTC derivatives, dealers have set up derivative product companies, SPV subsidiaries that trade with counterparties who need a top credit rating even though the parent is rated lower. The SPV is well capitalised, keeps market risk small by hedging its trades, often through a mirror trade with the parent, and follows rules that trigger a wind-down before its capital is exhausted. SPVs are also used in securitisation, where a dealer's swap with the vehicle can be repaid only from the vehicle's assets. The key point is that the SPV's strength rests on its capital and structure, not on a parent guarantee. In termination, its counterparties' claims rank equally and share the assets pro rata.

A practice question

From the question bank, with the reason each wrong option is wrong.

What is the key feature of a special purpose vehicle used in OTC derivatives dealings?

  1. A separate, bankruptcy-remote entity with ring-fenced assets - correct
  2. An unincorporated trading desk that shares the parent's balance sheetWhy not: Sharing the balance sheet means no legal separation, which defeats the purpose of an SPV.
  3. A clearing house owned by members that mutualises lossesWhy not: This describes a CCP, not an SPV.
  4. A rating agency affiliate that certifies the dealer's credit qualityWhy not: SPVs are trading or financing entities, not rating providers.

The legal separation and ring-fencing of assets mean that the SPV's creditworthiness depends on its own capital and structure rather than on the sponsor's.

A harder one

A derivative product company is rated higher than its parent bank. Which explanation is most accurate?

  1. A parent guarantee on every trade lifts it above the parent's own rating.Why not: A guarantee cannot make the subsidiary safer than the guarantor.
  2. Government support is given to all subsidiaries of dealers.Why not: Support for bank subsidiaries is not the basis of these vehicles' ratings.
  3. Separate capital, bankruptcy remoteness and strict risk limits - correct
  4. Netting across counterparties removes all of its credit risk.Why not: Netting reduces exposure but does not eliminate credit risk.

The rating comes from the structure: dedicated capital, limited market risk, bankruptcy remoteness, and wind-down triggers, not from the parent's strength.

The hardest tier

A derivative product company offsets each customer trade with an identical opposite trade with its parent. Which risk remains with the vehicle?

  1. Credit exposure to the parent on the mirror trade - correct
  2. None, since the trades offset exactlyWhy not: Offsetting positions remove market risk, not the credit risk on the parent.
  3. Market risk from the position, since a mirror trade removes only credit riskWhy not: Reverses the purpose: mirroring is meant to remove market risk, not credit risk.
  4. Liquidity risk from daily margin calls by a CCPWhy not: In this structure the trades are bilateral with the parent, not cleared.

The mirror trade neutralises market risk, but the vehicle depends on the parent for payments on it. That credit exposure is managed through collateral and capital rules.

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