Credit & Counterparty

Every hedge or trade carries the risk that the counterparty on the other side fails to perform. This hub covers how counterparty exposure is measured and mitigated — from credit support annexes and collateral to CVA.

How it works

Two related risks sit here. Credit risk is the risk a borrower or bond issuer defaults, priced through the spread over the risk-free curve. Counterparty credit risk (CCR) is the risk that the party on the other side of a derivative defaults before the trade settles — an exposure that changes as the trade moves in or out of the money. The market price of that risk is the Credit Valuation Adjustment (CVA): an adjustment to a derivative’s value for the expected cost of counterparty default. CVA moves with both the counterparty’s credit spread and the size of the exposure.

In practice

CCR is mitigated by netting, collateral and hedging. The ISDA Credit Support Annex (CSA) governs collateral — posting initial and variation margin as exposures move — which can reduce or even neutralise CVA. Regulators require capital against it: the Standardised Approach for Counterparty Credit Risk (SA-CCR) measures exposure, while SA-CVA/BA-CVA capitalise CVA risk itself. Central clearing further concentrates and mutualises counterparty risk through CCPs — reducing bilateral risk but raising the importance of margin and clearing-house resilience.

Credit default swaps (CDS)

The traded instrument for credit risk is the credit default swap (CDS) — effectively insurance against default. The protection buyer pays a periodic premium, the CDS spread (in basis points on a notional), and receives a payout if the reference entity suffers an ISDA-defined credit event (bankruptcy, failure to pay, or restructuring). The spread is a direct market read on default probability: a name trading at 500 bp is priced as far riskier than one at 50 bp. CDS trade single-name (one issuer) and as indices — CDX in North America, iTraxx in Europe — which let a desk hedge or express a view on a whole basket of credit in a single trade.

For a commodity or trading business, CDS matter two ways. They price the credit of the counterparties and issuers you face — a supplier, an offtaker, a lending bank — turning creditworthiness into an observable number. And they offer a way to hedge a concentrated exposure whose default would hurt, such as a utility holding a large, long-dated contract with one producer. CVA desks use the same CDS (or proxy) spreads to hedge the credit-spread component of counterparty risk.

Counterparty risk in commodity markets

Commodity trading carries counterparty risk on both a physical and a financial leg, frequently at the same time: a cargo may be delivered before payment clears, while the hedge against it sits as an OTC swap or an exchange future. Exchange-traded positions are margined daily through a clearing house, so that risk is largely mutualised — but bilateral OTC trades and long-dated offtake, tolling and power-purchase agreements (PPAs) carry years of uncollateralised exposure to a single name. Three features make commodity counterparty risk distinctive:

• Wrong-way risk. A producer’s creditworthiness is often correlated with the very price you are exposed to. A producer that has sold forward is most likely to default when prices spike against it — precisely when your exposure to it is largest.
• Margin and liquidity spirals. Because so much hedging is exchange-cleared, a sharp price move triggers large variation-margin calls. In the 2022 European energy crisis the BIS documented intraday margin calls worth hundreds of millions of dollars, straining even solvent, fully hedged firms and pushing some to cut hedging — turning a liquidity problem into a market-wide one.
• Credit support beyond clearing. Physical and OTC commodity trades are underpinned by parent guarantees, letters of credit, prepayment and ISDA/CSA collateral rather than a CCP — so the strength of that credit support, not the trade alone, defines the real exposure.