What is the Current Exposure Method (CEM)?
The current exposure method (CEM) is a system used by financial institutions to measure the risks around losing anticipated cash flows from their derivatives portfolios due to counterparty default. The current exposure method highlights the replacement cost of a derivative contract and suggests a capital buffer that should be maintained against the potential default risk.
Understanding the Current Exposure Method (CEM)
Banks and other financial institutions have typically used the current exposure method to model their exposure on particular derivatives in order to allocate sufficient capital to cover potential counterparty risks. Under the current exposure method, a financial institution's total exposure is equal to the replacement cost of all marked to market contracts plus an add-on that is meant to reflect the potential future exposure (PFE). The add-on is the notional principal amount of the underlying that has a weighting applied to in. Put more simply, the total exposure is under CEM will be a percentage of the total value of the trade. The type of asset underlying the derivative will have a different weighting applied based on the asset type and the maturity.
For example, an interest rate derivative with a maturity of one to five years will have a PFE add-on of 0.5% but a precious metals derivative excluding gold would have an add on of 7%. So a $1 million dollar contract for an interest rate swap has a PFE of $5,000 but a similar contract for precious metals has a PFE of $70,000. In reality, most contracts are for much larger dollar figures and financial institutions hold many, with some playing offsetting roles. So the current exposure method is meant to help a bank show that it has set enough capital aside to cover overall negative exposure.
The History Behind the Current Exposure Method
The current exposure method was codified under the first Basel accords to deal specifically with counterparty credit risk (CCR) in over-the-counter (OTC) derivatives. The Basel Committee on Banking Supervision's goal is to improve the financial sector's ability to deal with financial stress. Through improving risk management and bank transparency, the international accord hopes to avoid a domino-effect of failing institutions.
Despite the current exposure method being in practice, its limitations were exposed through the financial crisis that began, in part, due to insufficient capital to cover derivatives exposure at financial institutions. The main criticism of CEM pointed to the lack of differentiation between margined and unmargined transactions. Further, the existing risk determination methods were too focused on current pricing rather than on fluctuations of cash flows in the future. To counteract this, the Basel Committee published the Standardized Approach to Counterparty Credit Risk (SA-CCR) in 2017 to replace both the CEM and the standardized method (an alternative to CEM). The SA-CCR generally applies higher add-on factors to most of the asset classes and increases the categories within those classes.