Treasury Essentials

What is counterparty risk for a corporate entity?

Counterparty risk is the likelihood that a counterparty in a financial transaction might default on, or otherwise fail to, meet its contractual obligations under that transaction.

This can be relevant for a corporate entity in a number of different financial arrangements and transactions (credit, investment and trading). For instance, when a corporate is relying on borrowings under an upcoming or ongoing lending arrangement, a failure by the bank counterparty to lend monies when due is likely to cause inconvenience and related consequential costs.

Counterparty risk is however of particular importance for any transactions a corporate entity enters into which has (or has the potential to have) a positive value to the corporate entity at the time of default.   For such transactions the corporate is risking direct economic loss. 

An obvious example here is derivative transactions and we will focus our discussion below on those.   Many corporates will enter into over the counter (OTC) derivatives to hedge exposure they have to fluctuating interest rates and FX, for example.  Corporates might enter into a range of derivatives for other purposes, mainly hedging.  The nature of a derivative transaction, where both parties have payment or delivery obligations, means the corporate entity has the potential, depending on fluctuations in market values or rates, to be the party that is in-the-money, and thus exposed to counterparty risk, at any time.

How does a corporate assess counterparty risk?

A corporate entity should firstly look at the probability of default or failure by the counterparty (whether that be a complete failure or failure to meet obligations in a timely manner) and secondly estimate the loss or other consequences it is likely to incur or suffer if there is a default or failure by the counterparty. 

A corporate should  evaluate the counterparty risk as part of its counterparty selection process before the first trade is entered into and/or the ISDA Master Agreement is agreed, but credit worthiness should also be assessed each time a new transaction is entered into (to assess whether the counterparty risk is still acceptable and/or whether the credit-related terms and pricing of the transaction are suitable), and, to an extent, on an ongoing basis throughout the life of outstanding trades (for example, to assess if immediate action is needed to serve notice to protect its rights or otherwise communicate with counterparty, or enter into alternative arrangements such as collateral arrangements).

What type of counterparty is the corporate facing? Is your counterparty a bank or building society that is subject to a resolution regime? If so, what resolution regime is it subject to and what, if any, provisions have been included in the derivatives documentation (by way of ISDA protocol or otherwise) dealing with resolution?  This would be relevant in assessing whether your right to terminate or enforce will be subject to stays.  If your counterparty is not subject to a resolution regime, insolvency is a possibility.

The kinds of credit checks that a bank will undertake to determine the risk profile of a borrower (credit score, existing debt and debt capacity) are not the same and not typically available for a corporate to undertake against a financial institution or other non-corporate counterparty.  A corporate can however look at a counterparty’s credit rating from agencies such as Moody’s, Standard & Poor’s and Fitch.

Is the counterparty part of a larger group and dependent on another group member for its credit standing?  We look at how this and other counterparty concerns can be dealt with below.

What protections allow a corporate entity entering into derivatives to manage and mitigate counterparty risk?

Regulatory protections. Some of the largest corporates trading high volumes of derivatives, together with their counterparties, may be subject to regulatory obligations to clear OTC derivatives or to post regulatory margin (both of which do address and provide a level of protection against counterparty credit risk). Most corporates are likely to be subject to other regulatory risk mitigation requirements in relation to their OTC derivatives, but will not be, and neither will their counterparties in respect of such transactions be, subject to the clearing and margin requirements. 

Standard provisions of the ISDA Master Agreement.   The ISDA Master Agreement incorporates many protections as standard, which protect against counterparty risk.  To name a few:

• Close out netting is designed to reduce counterparty risk. When the right to terminate has been exercised on the occurrence of an event of default or termination event, all transactions (or certain transactions, in the case of certain Termination Events) under an ISDA Master Agreement are subject to close out netting which effectively means that instead of termination payments potentially being due under some transactions to the defaulting party and due under other transactions to the non-defaulting party, all future payment obligations are cancelled, netted off against each other and one single termination amount is due. 
• The standard events of default and termination events in the ISDA Master Agreement (e.g. Failure to Pay or Deliver, Credit Support Default, Misrepresentation, Default under Specified Transaction, Cross Default, Bankruptcy, Merger without Assumption, Credit Event upon Merger) do of course protect a party against unfavourable counterparty events, actions or inactions.
• The condition precedent in Section 2(a)(iii) (which provides that all payment and delivery obligations are subject to the condition precedent that no Event of Default or Potential Event of Default has occurred and is continuing with respect to the other party and that no Early Termination Date has occurred or been effectively designated) is designed to protect against credit risk of an insolvent or a defaulting party. If a non-defaulting party is otherwise obliged to make payment or delivery to a defaulting party in ongoing transactions, Section 2(a)(iii) allows the non-defaulting party to effectively withhold performance and payment whilst the condition precedent is not satisfied.

How does a corporate enhance protection against counterparty risk in an ISDA Master Agreement?

Focussing discussion mainly again on the ISDA Master Agreement, below are some ways a corporate can consider enhancing protection against counterparty risk:

• Election of certain events of default and termination events - not all of the standard events of default and termination events in the ISDA Master Agreement are automatically “switched on” (e.g. Cross Default, Automatic Termination in relation to certain Bankruptcy events, Credit Event upon Merger) so it is important to elect them as applicable if considered to be desirable or necessary.
• Additional Termination Events - Additional Termination Events can be added to the Schedule to the ISDA Master Agreement if it is felt that the standard events do not provide adequate protection against particular counterparty risk. For example, the credit rating of the counterparty might be such that a ratings-linked Additional Termination Event is felt necessary.  If creditworthiness of the counterparty is dependent on the control, ownership or support of another group member, a corporate should think about a change of control provision addressing adverse material change in control or ownership and/or linking to a downgrade in the relevant group entity’s credit rating.  If the counterparty is a hedge fund you may include a termination event linked to a decline in net asset value.
• Credit Support, Credit Support Providers and Specified Entities - Where a counterparty is not considered to have desirable creditworthiness, it may be possible for a group member or third party to provide credit support in relation to the obligations of the counterparty, in the form of a guarantee or pledge, for example. In such instance, such entity can be added as a Credit Support Provider. If the counterparty is part of a larger group, it may be desirable to designate other asset-rich or significant group members as “Specified Entities”.  Designating Credit Support Providers and/or Specified Entities has the effect of broadening the scope of certain events of default and termination events (e.g. Cross Default, Default under Specified Transaction, Bankruptcy and Credit Event upon Merger) such that they can be triggered upon occurrence of such event in relation to the Specified Entity or Credit Support Provider rather than solely the counterparty. Parties separately also have the ability to enter into a Credit Support Annex under the ISDA Master Agreement, under which collateral is posted by either party to mitigate counterparty credit risk it has in relation to the exposure it has towards the other party.
• Cross Default - Note that some negotiations of the ISDA Master Agreement involve amending the Cross Default provisions (which deal with defaults under other agreements in respect of borrowed money between the parties) to become a “cross acceleration” provision. This actually weakens the effect of the cross default clause so that it cannot be triggered at the earlier point in time when a debt is capable of being declared due and payable but there has to be an actual acceleration of the debt for it to be triggered (though this will usually apply bilaterally such that the corporate will also benefit from having a cross acceleration trigger at a later point in time).  Carve-outs are often requested  by bank counterparties in relation to cross default such that deposits received by the bank in the ordinary course of business should be excluded. Whilst this carve-out is generally considered acceptable, failure to repay deposits could potentially indicate serious credit problems unless due to the imposition of a legal or regulatory prohibition - so it would be prudent to ensure any such carve out is drafted carefully.  A carve out for cross default is often negotiated for technical or operational issues but again, it would be prudent to ensure that the carve out is qualified (it only applies so long as such issue is resolved within a certain number of days and/or so long as the counterparty has available funds). Another element of the Cross Default clause which is negotiated is the Threshold Amount, being the amount above which the default triggers the right to terminate under the ISDA Master Agreement.
• Noting the differences between 1992 and 2002 ISDA Master Agreements - The 2002 ISDA Master Agreement has several default/termination events which are potentially easier to trigger as compared to equivalent provisions in the 1992 ISDA Master Agreement.  For instance, the scope of transactions covered by the Default under Specified Transaction event are wider in the 2002 ISDA Master Agreement, the Threshold Amount in the Cross Default clause operates in a different way potentially meaning a higher risk of being triggered in some instances, the Credit Event Upon Merger provision is expanded to cover UK style takeovers and other change of control and substantial change in capital structure, and grace periods are shorter. These differences should be considered alongside the other differences and benefits that can be gained from using a 2002 ISDA Master Agreement.

Bargaining strength and other considerations

There are many more ways a counterparty can amend standard provisions in the ISDA Master Agreement to improve the protection against counterparty risk.   As noted above, where the amendments apply bilaterally there is a balancing exercise of how much protection a corporate needs from a counterparty and how stringent the terms the corporate is willing to be subject to. When a corporate negotiates to achieve a more favourable position to protect against counterparty risk, the relative bargaining position between the corporate and its counterparty and factors such as internal credit policies will ultimately dictate whether the parties end up in the same or similar position or whether the agreement ends up being more one sided with greater protection for one of the parties.   When negotiating, the corporate entity must always bear in mind which of the parties the provision is more likely to impact. The parties might also be constrained by what is agreed for similar provisions in other related finance documents if the derivative is part of a wider financing arrangement.   Be mindful of any provisions commonly agreed in derivatives documentation for the contractual recognition of the application of regulatory stays or overrides of certain termination rights under special resolution regimes to which the counterparty is subject.  Also be mindful of any right to set-off in relation to the early termination payment which may be expanded to apply to affiliates of a counterparty or otherwise negotiated in your ISDA Master Agreement.

Bank Dynamics

• Some banks are displaying new levels of caution. In particular, concern about holding credit positions on their own balance sheets and increased focus on clearing the loan book. At the forefront of discussions will be an emphasis on syndication and refinancing bridge and other interim debt.
• Higher pricing and tighter terms are being felt across the board in all aspects of lending activity. For M&A, 2022 saw a significant reduction in bank lending and several major cases of banks stranded in “hung” positions, unable to syndicate underwritten exposures without incurring material losses. To a large extent private credit has stepped in to fill the gap in the LBO markets, but at higher rates.
• Regulation, particularly merger control, is in some cases having an impact on the cost of bid finance. Regulatory agencies taking a more interventionist stance has led, in some cases, to a longer period between signing and closing of acquisitions. This in turn has pushed up the cost of bridge debt as commitments are held for an extended period.
• Moving through 2023, while we expect lender caution to persist, with an eye to syndication and take-out options, strong credits should continue to be able to access debt finance although this is likely to remain at a higher cost of capital. Alternative debt providers will continue to be a major participant in private equity-backed deals and may be a solution for corporate acquirors further down the credit spectrum.

Acquiror Dynamics

• Sponsor and other fund-backed activity has been impacted during the last year, as returns have been hit by the higher cost of capital. Coupled with caution being displayed by certain lenders and a reluctance to lend at the high leverage multiples typically advanced in sponsor backed LBOs, we have seen a drop in private equity-backed bids over the last twelve months.
• Some sponsors have adapted by entering into consortium or co-investor backed bids to support a successful financing package, or increasing their equity contribution to get the deal over the line.
• Against this backdrop, we expect well capitalised companies to continue to seek strategic or bolt-on acquisitions, perhaps aided by suppressed valuations that are being felt across a number of industries. Alternative funding structures may also help to mitigate some of the increased cost of borrowing. What these structures will look like will vary, but may include, for example, borrowing at the target level or introducing deferred or contingent payment mechanics.
• As a final note, tax remains, as ever, a key consideration. In a world of rising interest rates, getting effective tax relief for interest costs will be important. Groups may increasingly find relief capped under interest restriction rules introduced during the last five years, which operate by reference to a percentage of EBITDA. Matching deductions to operating income has also become less straightforward. In particular, where debt funding flows through a number of newly incorporated group companies in an acquisition structure, deductions could be challenged under anti-avoidance rules, unless they have a clear commercial rationale.

For more information, please see our report on M&A in 2023.

USD LIBOR transition

For those with continuing USD LIBOR exposures, the clock is ticking. The FCA’s announcement that 1, 3 and 6-month synthetic rates will be available for a short period is welcome given the sheer volume of outstanding USD LIBOR exposures.  The FCA and other regulators have, however, made clear that market participants should remain focussed on actively transitioning legacy USD LIBOR-referencing products before end-June 2023 where feasible.

Loans – SOFR rate options

Those transitioning loans from USD LIBOR in the London market in most cases must make a choice between Term SOFR and SOFR compounded in arrears[1]. The LMA has produced drafting for both rate options. Both are valid choices. The decision is influenced by a range of factors. These include which rate is operationally easiest or feasible, (in some cases) whether lenders are licenced to use Term SOFR and (in hedged deals) whether hedging is available on terms that are commercially acceptable.

The Alternative Reference Rate Committee’s recent update to its Term SOFR Scope of Use Best Practice Recommendations, to permit dealers to enter into Term SOFR-SOFR basis swaps with non-dealer market participants, is aimed at easing the build-up of one-way Term SOFR risk at dealers and thus supporting the availability of Term SOFR hedges.  Term SOFR hedging appears to be more expensive given that compounded in arrears SOFR is the standard in the derivatives market. This is expected to continue and will be an important factor in the choice of SOFR rate for treasurers looking to hedge SOFR loans.

The availability of LMA drafting for multi-currency facilities incorporating Term SOFR has made documenting a Term SOFR loan alongside compounded in arrears rates for other ex-LIBOR currencies much simpler. The LMA’s facilities referencing Term SOFR (available to members from the LMA website) were updated from exposure drafts to LMA recommended forms on 25 May 2023.

The most appropriate long-term fallbacks for Term SOFR remain a topic for discussion. Options include compounded in arrears SOFR, or (if Term SOFR has been used to avoid using compounded in arrears rates) a central bank rate (which has a parallel in the customary fallbacks for compounded in arrears risk-free rates). Both of these options are included in the LMA’s Term SOFR drafting.

For further information on LIBOR transition in the loan market and the LMA’s drafting, treasurers are referred to the ACT’s most recent Borrower’s Guide to the LMA’s Investment Grade Agreements.

Bonds – USD LIBOR transition work continues

The replacement rate for USD LIBOR in the bond market is compounded in arrears SOFR. Term SOFR is not generally being used as a reference rate for new issuance.

Although the transition away from USD LIBOR on legacy bonds is steadily progressing, the size of the legacy USD LIBOR bond market remains considerable. Active transition in the bond markets involves a bond-by-bond consent solicitation process, which can be a time-consuming and costly exercise for issuers. USD LIBOR bonds, in particular, have a more geographically diverse investor base, which can make active transition even more challenging.

The FCA’s decision to permit the use of synthetic USD LIBOR for legacy USD LIBOR bonds is helpful for the bond markets as it will provide an additional window for legacy bonds to be actively transitioned or to allow such bonds to mature. Whether synthetic LIBOR applies to bonds not governed by English law (for example New York law bonds) will involve an analysis of any applicable local regime for tough legacy contracts.

Even with the extended window to September 2024, issuers with outstanding USD LIBOR bonds are encouraged to start putting in place their transition plans without delay. Legacy LIBOR bond terms may not envisage permanent LIBOR cessation and may therefore, without any further action, ultimately fall back to a fixed rate, which is not likely to have been the intention of the parties.

Derivatives – fallbacks and basis risk

The main options for transitioning legacy USD LIBOR derivatives remain unchanged - (i) adhere to the ISDA 2020 IBOR Fallbacks Protocol (the Protocol), which enables adhering parties to incorporate robust fallback provisions into their contracts so that, provided both parties have adhered, a market agreed fallback rate will apply automatically after the 30 June USD LIBOR end-date, or (ii) bilaterally agree a fallback rate, either by incorporating the terms of the Protocol or agreeing alternative fallbacks.

The most appropriate and viable option will depend in part on the number of agreements which need to be transitioned, and in part on the replacement rate being used in any underlying cash product.

Treasurers will want to ensure that the fallback rates in the derivative match as closely as possible with the replacement rate in the cash product to avoid any basis risk. Even where both products are transitioning to compounded in arrears SOFR, there is some potential for a mismatch given the different calculation methodologies and conventions used in the different markets.

Given the limited time available to transition away from USD LIBOR, if the degree of basis risk is unacceptable, the parties may choose to adopt the fallback terms of the Protocol and then later bilaterally negotiate changes to their contracts to achieve greater consistency between the replacement rates and thus reduce basis risk.

The issue of mismatch and basis risk will also be relevant to securitisations where, in addition to operational and procedural considerations, there will be a focus on minimising mismatches between any floating rate notes, interest rate swaps, and the rates applicable to the underlying securitised assets.

Other news - CDOR and EURIBOR

A number of jurisdictions around the world are transitioning domestic IBORs to risk-free rates, following the path trodden by the LIBOR currency jurisdictions. Users should keep developments in relation to all domestic currency benchmarks under review.

Considerable progress has been made in Canada. CDOR, the Canadian Dollar Offered Rate, will cease in June 2024 and is being replaced by CORRA, the Canadian Overnight Repo Rate Average. CORRA compounded in arrears is starting to be used; in February 2023, the LMA published a compounded CORRA schedule to provide loan market participants with a suggested form of drafting for use of compounded in arrears CORRA, which largely follows the form of the other currency schedules already contained in the LMA’s compounded rate recommended form facilities agreements. A Term CORRA rate is also being developed; the use cases include loans and trade finance.

Although there are still no plans to discontinue EURIBOR, the Working Group on Euro Risk-Free Rates remains focussed on the need to implement robust fallback provisions in EURIBOR-referencing products to address any future discontinuation. To this end, it has recently published further guidance on fallbacks for corporate lending products, in which, given a lack of adoption to date in the loan market, it reiterates its May 2021 recommendations on EURIBOR fallback rates and triggers, and provides additional clarity on applicable conventions. 

In light of this additional guidance aimed specifically at the loan market, borrowers can expect EURIBOR fallbacks to feature in future discussions on new and refinanced EURIBOR-referencing loans. The LMA’s facility templates include drafting for compounded in arrears €STR which can be used in fallback provisions; Term €STR provisions are anticipated shortly.

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[1] There was no similar debate in the context of GBP LIBOR because, although a term rate is available for SONIA, the UK regulators have consistently ruled out its use in corporate loans.