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Outline how termination provisions and trade compressions work and account for their strengths and weaknesses.

FRM® Part II · Credit Risk Measurement and Management · Netting, Close-out and Related Aspects · FRM2.CR.16.d

The idea

Termination provisions let a party end transactions early and settle them at market value, which limits how long it stays exposed. A mutual break clause allows either party to terminate on a stated date, for instance the fifth year of a ten-year swap. An additional termination event, such as a rating downgrade or a fall in a fund's net asset value, gives the unaffected party the right to terminate when credit quality deteriorates. The weaknesses are that triggers lag the deterioration, can be breached suddenly, and demand a payment from a counterparty already under stress. They can therefore be procyclical and speed up its failure. Trade compression removes redundant or offsetting trades, bilaterally or among several participants, and replaces them with fewer ones. It cuts gross notional, trade count, operational burden and capital. It leaves net market risk and net exposure essentially unchanged. Compression is not a way to reduce net credit exposure.

A practice question

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

What is trade compression in the OTC derivatives market?

  1. Collecting variation margin each day so that exposure is kept close to zeroWhy not: Describes collateralisation, which reduces exposure without removing trades.
  2. Terminating redundant or offsetting trades and replacing them with fewer or smaller ones, leaving net risk essentially unchanged - correct
  3. Moving trades to a clearing house through novation so that it becomes the counterpartyWhy not: Describes central clearing; compression can be done bilaterally or multilaterally without it.
  4. Shortening the maturity of trades by early termination at a discount to market valueWhy not: Compression is not a discounted termination; offsetting trades are removed and net positions are preserved.

Compression reduces gross notional and the number of trades. It does not change each participant's net market position.

A harder one

What is the main strength of a termination provision such as a break clause or a rating-downgrade trigger for the party that holds the right?

  1. It fixes the termination value at the price in the original ConfirmationWhy not: Termination is at market value at the time, not at the original trade price.
  2. It guarantees that the counterparty will be able to pay the termination amountWhy not: Termination does not guarantee payment; a stressed counterparty may still fail to pay.
  3. It allows the party to crystallise the exposure at market value before the counterparty defaults, which limits the period of risk - correct
  4. It removes the need for any collateral agreement with the counterpartyWhy not: Termination rights complement collateral; they do not replace margining and carry gap risk.

The right to terminate shortens the effective maturity of the credit exposure and converts a future claim into a current one at fair value.

The hardest tier

A bank has an additional termination event allowing it to terminate if a counterparty is downgraded below BBB-. The counterparty, rated BBB+, announces a large accounting fraud and is cut to BB in one action. The bank is in the money by USD 40 million. Which weakness of the provision is best illustrated?

  1. The bank cannot terminate because a downgrade is not an Event of DefaultWhy not: An additional termination event is a separate right and does not require a default.
  2. The bank loses the netting benefit on its other trades with the counterpartyWhy not: Close-out netting still applies to all terminated trades under the single agreement.
  3. The termination amount must be computed at the original trade pricesWhy not: Termination amounts are computed at current market values, not original prices.
  4. Ratings lag credit deterioration, and termination only helps if the stressed counterparty can then pay the amount due - correct

A trigger is hit only after the credit has fallen, and exercising it demands USD 40 million from a counterparty already in distress, so the bank may still suffer a loss. Triggers can also be procyclical.

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