Four levels of counter-party security in Drybulk

The tanker market has eliminated credit risks and counter party risks elegantly by adopting cleared trading in smaller lot sizes. This enables principals dealing in the tanker derivatives market to combine hedging and speculation in a highly liquid marketplace. Triple digit growth in the tanker derivatives market, resulting in a high level of intra-day liquidity on most contracts is a direct result of this approach.

Adopting smaller lot sizes, going for all-days settlement, and the elimination of counterparty, and contract risk is going to be the next big thing in the drybulk freight derivatives market.

In this article we look at counter-party risk, and we will look at issues related to contract risk, market price manipulation, all-days settlement and liquidity in the weeks to come.

Essentially counter-party security comes in four main categories:

1.         Critical / Very high risk - Insecurity by trading OTC with untested, but known counterparties.

Losses from FFA defaults occur more regularly than in any other sector of the market. Because of the high risks involved the potential for reward, and loss, attracts a large number of principals to this market. Many do not have the balance sheet, risk management systems or trading expertise to control their exposure. You can expect a very high level of market price manipulation in this sector of the market.

2.         High risk - Relative insecurity of FFAs between known counterparties.

FFAs are essentially un-priced credit risks, and this is the most common form of freight derivative. The inherent risk of OTC FFA trading is that if one party makes a loss, this could easily have a domino effect on you if you’re exposed to the loss maker, regardless of the balance sheet and risk management expertise of the company. This is why losses are so common. OTC FFAs are on offer from the majority of large ship broking firms and certain specialised FFA broking shops. This sector of the market is commonly used by generic shipping companies to hedge their exposures to risks in the underlying market, but is not well suited to speculative trading in freight derivatives. You can expect a relatively high level of market price, which makes it unattractive for new or smaller principals.

3.         Medium risk - Relative security by converting OTC contracts to cleared contracts.

This is an increasingly popular way into clearing, where a clearing house takes on the counter-party risk against collateral (margin). However OTC conversion carries inherent risk from the potentially long time it takes to process each contract. Before a trade is reported and accepted for clearing, the market may have moved substantially against one of the parties. OTC conversion also carries a higher cost. Participants still see a relatively high level of market price manipulation, which again makes it quite unattractive for new or smaller principals. Also, OTC conversion is more expensive than straight-through clearing.

4.         Low risk - Security by trading cleared contracts with straight-through processing to clearing house which takes the credit risk.

This has become the trading method of choice for the tanker market because it offers zero counterparty risk, liquid screen trading with anonymous counterparties and there is virtually no market price manipulation. Straight through clearing offers full elimination of credit risk from the point of trade with no delay as trades are reported and accepted manually. Other benefits include potential for smaller lot sizes, all-days settlement and daily mark-to-market calculations for dynamic profit and loss calculations.

The key argument for straight through clearing came home to the freight derivatives community last summer when a drybulk freight derivatives default occurred. Over US$6,5 million was lost in risk levels 1 and 2 of the OTC market, whilst the default on cleared trades in risk level 4 carried no loss for the counter-parties. Some put the losses mounting in levels 1 and 2 much higher than what has so far been confirmed.

Trading freight derivatives OTC, is a balancing act between getting access to good prices and good credit quality. Often these contradict each other. The result is that companies can get tempted to accept poor unknown or undocumented credit. Companies that carry stringent and well thought through credit policies, both spend considerable resources in order to establish and monitor credit lines as well as restricting the trading operation an optimal playing ground with a maximum of potential counterparts.

Even if companies put serious effort into their "credit matrix", which details who are the acceptable counterparts with approved lines of business,  the default risk is still there. Research tells us that size of counterpart does not give acceptable comfort.

The popular notion that big companies carry acceptable credit risk is in fact a myth. An analysis done by (paradoxically enough) Enron showed clearly that there is little correlation between size and default risk.

Even historical performance is not considered a tested credit benchmark. In the freight market a number of big and small companies have defaulted on their payments; Enron (big), Andre-Group (quite big), TXU (European trading arm, (medium), Navitrans (small/medium), and Kingston Maritime (small)

Profitable long term trading in the freight derivatives market invariably contains a mix of speculative bets and hedging positions. To achieve this, traders rely essentially on four key factors in the marketplace they trade:

• Acceptable but small counter party risks (credit and contract)
• A liquid deal-flow
• Minimal market price manipulation
• Smaller lot sizes which are easier to buy and sell
   

The following table shows how the various levels of counter-party risk in the drybulk freight derivatives market, compare when trying to achieve these trading conditions:

Securing profits by eliminating counter-party risk is however, the only truly professional approach. This can only be achieved by straight through clearing of Drybulk derivatives.

Credit risk is a dynamic picture.

Remember: The credit position of your counterpart varies according to market direction as well as operational performance. Your counterpart's exposure to FFA credit risk is in itself an aspect that can make an otherwise solid counterpart weak. The only way to trade with zero counterparty risk, is by way of straight through clearing, which you can get 24 hours per day at Imarex.

To trade drybulk freight derivatives with confidence, call Imarex in Oslo on +47 2389 4220 or in Singapore on +65 6720 0050