Data reported by U.S. banks indicate that, on average, netting now reduces counterparty exposures by almost three-fourths. Even with wider use of netting, however, the outsized growth of derivatives markets has resulted in ever-larger counterparty exposures. Market participants have increasingly responded by entering into collateral agreements to further mitigate counterparty credit risks.
Such agreements typically permit counterparties to derivatives transactions to demand collateral if their net credit exposure exceeds a negotiated threshold amount. The threshold often varies with the credit rating of the counterparty: The lower a counterparty’s credit rating, the smaller the threshold. If its credit rating falls below investment grade, a counterparty is often required to overcollateralize its counterparties’ exposures.