Emerging Practices for Capital Adequacy © Copyright 2003, CCRO. All rights reserved. 56 • Specific contractual requirements – In a trigger event, contracts may require specific adequate assurance. For example, a pipeline or storage facility may require acceleration of demand payments for adequate assurance even though the position is in the money or gas is in inventory. 8.6.3 Debt/Equity Trigger Violation of a company’s financial debt covenants or equity trigger events may contribute to an increase in contingent liquidity. Most companies have worked toward eliminating contractual language that causes these trigger events in an effort to reduce liquidity requirements. If these contractual events do exist, they should be included in contingent liquidity calculations and disclosure. 8.6.4 Credit/Counterparty Terminations/Defaults Cash flow can be lost on replacement value of contracts due to a default event. For example, a company has an in-the-money (positive mark-to-market) position with a counterparty, and the counterparty ends up defaulting. This position was completely hedged with another counterparty over the life of contract, and the hedge was out-of-the-money (negative mark-to-market). In this situation, the company would have to replace the contracts of the defaulting counterparty at a loss and seek recovery from that counterparty through bankruptcy or arbitration. If a company chooses not to replace contracts, it increases market risk. Regardless of the decision to replace contracts, a company is still expected to perform on the hedge contracts of the unaffected counterparty. Consequently, the company becomes exposed to additional and unexpected demand for cash for the difference between the hedge price and replacement price of contracts or market value of contracts. Modeling the impact on liquidity as a result of credit defaults can be very complex. Most companies use a portfolio approach and do not always tie a hedge to a specific transaction. For this reason and others, it is difficult to assess the probability of liquidity demands. Given the complexity, it may be difficult to map exposures in CFAR calculation that relate to liquidity demands as a result of credit defaults. The CCRO recommends that companies use an expected and maximum scenario in modeling liquidity demands due to credit defaults and disclose assumptions. The contingent liquidity exposure would be additive to the exposure calculated under CFaR. 8.6.5 Operational/Operations Risk Operative risk may cause a cash flow loss due to an event not modeled under market or credit risk. This could be a key system failure, plant loss, etc. As with liquidity risk for credit defaults, modeling the effect of operational/operations risk on liquidity risk is difficult. The CCRO recommends that companies use an expected and maximum scenario in modeling liquidity demands due to operational/operations risk and disclose assumptions. The contingent liquidity exposure would be additive to the exposure calculated under CFaR.