Counterparty Due Diligence

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• Counterparty Due Diligence
• Craig MacDougall
• Head of Credit
• ABN AMRO Futures Ltd. London

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Subject Matter

• Due Diligence
• Why?
• How?
• How Far Do We Go?
• What Questions To Ask?
• Where to Look For Possible Problems?
• How To Keep Up-To-Date
• When To Review
• Trends and Information Sources

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'Dont try to teach your grandma to suck eggs!'

• Definition -
• Charles Earle Funk says in Hog on Ice (Harper
  Row, New York, 1948). To teach ones grandmother
  to suck eggs To offer needless assistance to
  waste ones efforts upon futile matters
  especially, to offer advice to an expert. This
  particular expression is well over two hundred
  years old it is just a variation of an older
  theme that was absurd enough to appeal to the
  popular fancy. One of the earliest of these is
  given in Udalls translation of Apophthegmes
  (1542) from the works of Erasmus. It reads A
  swyne to teach Minerua, was a prouerbe, for which
  we sai Englyshe to teach our dame to spyne.
  That last bit was about an expression, dont try
  to teach a dame to spin.

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COUNTERPARTY DUE DILIGENCE

• WHY?

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COUNTERPARTY DUE DILIGENCE - WHY?
ANSWER- SCANDAL
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COUNTERPARTY DUE DILIGENCE - WHY?
Or even
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COUNTERPARTY DUE DILIGENCE - WHY?
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COUNTERPARTY DUE DILIGENCE - WHY?

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COUNTERPARTY DUE DILIGENCE - WHY?
In many loss given default situations, lack of
effective due diligence can be a significant
factor.
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How to KYC

• Client Visits.
• Financial Reports and Accounts.
• Compliance, Legal Checks and MLRs.
• Market Knowledge and Developments.
• Stock price performance (KMV etc).
• The WEB.
• Regular Reviews.

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How Far Should Due Diligence Go?

• A. As far as necessary to be comfortable!

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What are the vital questions?

• A. Clearly this is dependent on the type of risk
  and the type of client...
• Do you know your customer?
• Does their business make sense?
• Can they support the risk?
• Is the legal documentation enforceable?

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Client Visits (what to consider)

• Make real use of a client visit. Dont just sit
  in the CFOs office!
• Walk through systems.
• Speak to staff.
• Inspect ask for copies of other bank or broker
  facility documentation or get a letter of
  confirmation... dont allow your firm to be
  Dutch-auctioned.

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Client Visits (what to consider)

• Try to gain a good understanding of the clients
  business.
• Do you feel that senior management are effecting
  good control?
• Discuss their risk management processes?
• How do they control Operational Risk?
• Do they have a DR Site? - really?

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Client Visits (what to consider)

• Which VaR or DEaR method is used - historical
  simulation, parametric or Monte Carlo?
• Are the input variables sensible - confidence
  level, holding period, volatility, correlation,
  forward pricing?
• Are abnormal/tail event risks catered for?

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Client Visits (what to consider)

• Are any other portfolio risk management methods
  used and do they make sense?
• Do risk controls extend to limits by region,
  product, tenor and basis?
• What stress testing is performed?

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What Can Be Learned From Recent Events?

• Like price volatility, ratings downgrades can
  trigger huge calls
• In the Californian power crisis last year some
  firms had margin calls of US900mn in a single
  day, even when fully hedged!
• ...so how much risk capital and liquidity
  resources does the counterparty have?

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Financial Reports and Accounts

• Analyse the financial position thoroughly.
  Request clarification of unusual items or notes.
  Look out for dodgy deals e.g. round trip trades
  or granting options to raise premiums.
• Get bank and third party references if necessary.
• Get a feel for the management. What does your
  instinct tell you?

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Financial Reports and Accounts

• FAS133 FAS141 142 re derivatives goodwill,
  other intangibles and business combinations
• ...serious impact on firms income and equity base
  for impairment or trading assets may be
  overstated.

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What are the Compliance Regulatory Implications?

• A Management has the responsibility to effect
  proper control over its business.
• This means complying with regulatory
  requirements, company compliance rules and
  internal controls.

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Market Knowledge and Developments

• Make contact with counterparts at other firms,
  not just at home but overseas too. Risk groups
  such as PRMIA and FOA are an ideal way to do
  this.
• Have a good channel of communication with
  traders.
• Get access to as many information sources as
  possible.

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How often should you review?

• A. Regularly... Ideally shortly after inception
  and then at regular intervals, at least annually.
  Again, may vary.
• Ensure accounts come through on time.
• Ensure covenants are met.

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Future Trends?

• Credit due diligence is deepening and widening in
  scope in order for the bank or broker to know its
  customer.
• Some customers have prepared highly detailed
  information packs on relevant areas of their
  internal control processes.

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Where can third party information be obtained
from?

• A. There are some very useful providers of free
  information and many that charge for their
  services. See the attached non-exhaustive list.

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Third Party Information Websites