What it means
Derivatives are contracts whose value depends on something else, such as an interest rate, a currency or a commodity price. Many customers, especially large institutions, will only trade derivatives with counterparties (the other side of the deal) that have a top credit rating.
A derivative product company, often shortened to DPC, was designed to meet that need. The parent firm puts capital into the subsidiary and sets rules that limit the risks it can take.
For example, the DPC might be required to match its positions closely, hold more capital than the parent would need, and have an arrangement that closes out contracts in an orderly way if its capital falls too low. These features help it earn an AAA or similarly high rating.
For customers, the benefit is lower counterparty risk, which is the chance the other party fails to pay. For the parent, the benefit is that it can offer derivative services to clients who would otherwise insist on a higher-rated provider.
The cost is the capital tied up in the subsidiary. DPCs became popular in the 1990s, and they are less central today because of changes in rules and market practice.
Collateral agreements, central clearing and stricter capital rules now do much of the job that DPCs once did. Even so, the concept remains useful for understanding how financial firms manage trust and credit quality.
The structure also has limits. The strength of the DPC depends on the quality of its risk controls, and a rating is only an opinion about its ability to pay, not a guarantee.
Investors and rating agencies pay close attention to the rules that govern a DPC. These usually include limits on the types of contracts allowed, restrictions on paying dividends to the parent and a requirement to close out contracts in an orderly way if capital falls below a trigger level.
Such rules are called a firewall, because they aim to protect the subsidiary from the parent's problems.
In practice
Real-world examples.
Example
A pension fund wants to hedge interest rate risk with a $200 million swap but its rules only allow top-rated counterparties. It trades with a bank's DPC, which meets the rating test even though the parent bank is rated lower.
Example
A mid-sized investment bank sets up a DPC so it can win business from large corporate treasurers. The treasury team sees the extra capital held in the subsidiary as the price of that access.
Example
A multinational manufacturer arranges a currency forward with a highly rated DPC to fix the cost of $15 million of foreign supplies. The finance director records the contract and monitors the counterparty rating each quarter.
Formula
Calculation
Capital cover ratio = Capital held / Risk exposure
Suppose a DPC has $400 million of capital and its modelled maximum risk exposure on its trading positions is $250 million. Its capital cover ratio is $400 million / $250 million = 1.6, or 160%. If the parent requires a ratio of at least 150% to keep the high rating, the DPC meets the requirement, because $400 million / 1.5 = $266.67 million is the most exposure it could carry, which leaves about $16.67 million of room above the current $250 million.Case study
Seen in the real world.
Ridgemont Securities is a fictional investment bank used here as an illustrative case study. Its credit rating is solid but not top tier, and several large clients refuse to trade long-dated derivatives with it.
The bank creates a DPC subsidiary with $500 million of capital and strict rules requiring it to hedge nearly all of its risk. The subsidiary earns a top rating, and the bank's derivatives business grows by 40% over two years. The finance team notes that the capital tied up in the DPC could have been used elsewhere, so it reviews annually whether the extra business justifies the cost.
After the 2008 crisis, regulators in several countries tighten rules on derivatives, and Ridgemont's clients begin clearing more trades through central clearing houses. The DPC's role shrinks as a result, and the board decides to wind it down over three years, releasing about $350 million of capital back to the parent. The finance team notes that the structure served its purpose when the market needed it but became less useful once the rules changed.
Watch out
Common mistakes.
- Assuming a DPC is risk free. It is built to be very safe, but it can still fail if its controls break down.
- Confusing the DPC rating with the parent rating. The two can differ because the DPC has its own capital and rules.
- Forgetting the cost of tied-up capital. The parent must fund the subsidiary, and that capital cannot be used for other lending or trading.
Questions
People also ask.
Why did banks create derivative product companies?
They wanted to trade with clients who required top-rated counterparties. A separate, well-capitalised subsidiary let them meet that requirement without upgrading the entire parent.
Are DPCs still common?
They are far less common than they were in the 1990s. Collateral posting, central clearing and tougher capital rules have taken over much of their role.
What is counterparty risk?
It is the risk that the other side of a contract fails to meet its obligations. A DPC structure is designed to lower this risk for customers.
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