Volume 4— Credit Risk Management © Copyright 2002, CCRO. All rights reserved. 22 Table 2. Methods for Managing Credit Risk Exposure Method Description Cost Remarks Reduction Methods Reassessment of credit limits and volumetric limits New limits on counterparties Low Reduces liquidity Active position management Credit department actively recruits and tracks creditworthy counterparties Low Requires increased system and human resources Collateralization As credit limits and counterparty quality decreases, real collateral will be necessary Low Used and tested in futures market. Look for ways to consolidate collateral management. Exposure-reducing trades Reduce open positions with credit poor continue positions with credit rich Low Need for new counterparties, but attempts to retain liquidity Master netting Bilateral netting under multiple contracts net financial obligations between: 1) commodities, 2) physical/financial, 3) subsidiaries, and 4) national boundaries Low Some legal issues remain untested in US court Transfer Methods Credit derivatives Transfers credit risk on a name-by- name basis Varies* Only coverage on large names, liquidity Credit insurance Normally covers accounts receivable risk on a portfolio some firms have ventured into MTM risk Varies* Partial coverage, first loss provisions, time to payout 30-90 days on default Reduce and Transfer Multilateral Clearing Provides centralized multilateral netting, collateral management, and some form of performance guarantee Mod- erate Not tested in over-the- counter energy *Cost is proportional to credit quality and size Energy merchants use many reduction methods, sometimes at the expense of product and counterparty liquidity. Reducing credit and volumetric limits reduces a firm’s credit exposure, but also lowers liquidity and ability to trade certain products. New counterparties entering the market will do so with credit risk at the top of their list when building a forward energy book. Therefore, transferring contracts from credit poor to credit rich may create a challenge.