Counterparty Credit Limits: The Impact of a Risk-Mitigation Measure on Everyday Trading

TL;DR

This paper investigates how counterparty credit limits influence trade prices in foreign exchange markets, finding limited effects in practice but potential significant impacts under certain network configurations through modeling and simulation.

Contribution

It provides empirical evidence on CCL effects in FX trading and introduces a new model to simulate their impact under various network scenarios.

Findings

CCLs had little impact on most trades in the observed data.

Model simulations show CCLs can significantly affect trade prices in specific situations.

Abstract

A counterparty credit limit (CCL) is a limit that is imposed by a financial institution to cap its maximum possible exposure to a specified counterparty. CCLs help institutions to mitigate counterparty credit risk via selective diversification of their exposures. In this paper, we analyze how CCLs impact the prices that institutions pay for their trades during everyday trading. We study a high-quality data set from a large electronic trading platform in the foreign exchange spot market, which enables institutions to apply CCLs. We find empirically that CCLs had little impact on the vast majority of trades in this data. We also study the impact of CCLs using a new model of trading. By simulating our model with different underlying CCL networks, we highlight that CCLs can have a major impact in some situations.