Volume 4— Credit Risk Management © Copyright 2002, CCRO. All rights reserved. 25 agreement. We consider this effort, and our support thereof, to be a significant advance for the industry in terms of more efficiently using collateral, especially in today’s environment. 3.0 Transfer Methods 3.1 Credit Derivatives Credit derivatives are instruments that have their value associated with the probability of default of an underlying company. The most common example of a credit derivative is the default swap, under which payment is triggered on a counterparty’s bankruptcy or payment default. Under these events of default, the seller of the credit derivative is obligated to pay on the underlying obligation. Credit derivatives are strong mitigants to credit risk under most circumstances. If fairly priced, they are an effective means of reducing or protecting against exposure. However, the key is in the pricing and in the “perfection” of the hedge. The biggest drawback to their utilization thus far in the energy industry has been the lack of liquidity, or a secondary market, in these instruments. They are NOT widely accessible for most counterparties. Therefore, as with most products where there is a thinly traded market and little liquidity, the pricing of said instruments usually factors in such limitations. Credit derivatives have been structured to mitigate credit risk, but they may not perfectly hedge the risk. That is, the payoff of a credit derivative may not match the exposure (MTM and net accounts receivable) that arises from commercial transactions. Historical usage of credit derivatives has also been tainted by contractual challenges of factors surrounding a party’s default (for example, was the default in line with defaults covered by the derivative?), and also delays in payment (payouts may take from 30 to 90 days under some circumstances). Credit derivatives are effective mitigation tools, but increased utilization coupled with increased liquidity and “fair pricing” have probably been delayed, as opposed to accelerated, by today’s environment and especially by the collapse of Enron, one of the largest participants in the credit derivative game. 3.2 Credit Insurance Much like credit derivatives, credit insurance is an effective financial product for mitigating credit risk. The major difference between credit insurance and credit derivatives is that the insurance product is usually tailored to cover a group, or portfolio of counterparties, as opposed to a single party. Policies are written by insurance companies to cover particular types of risk – retail aggregator risk, for example. They will typically cover only accounts receivable risk, although more and more are being written that will cover well-defined MTM risk. Coverage will usually be stated in terms of an overall limit for the portfolio, as well as limits for individual counterparty events. As with derivatives, until credit insurance is more widely accepted, there will continue to be issues of depth of market and fairness of pricing that need to be overcome. Credit insurance also has the additional hurdle of requiring “proof of harm or proof of loss,” which further complicates the “perfection” of the hedge (i.e., the effectiveness of insurance as a credit risk mitigation tool). 4.0 Multilateral Clearing Far and away the greatest potential for advancement for the industry in terms of credit risk mitigation, improved liquidity, and capital adequacy is through clearing. Clearing provides the