A derivative product company is a special-purpose entity created to be a counterparty to financial derivative transactions. A derivative product company will often originate the derivative product to be sold or they may guarantee an existing derivative product or be an intermediary between two other parties in a derivatives transaction. Derivative product companies may also be referred to as “structured DPCs” or “credit derivative product companies (CDPC).”
A derivative product company is usually a subsidiary created by a securities firm or bank. These entities are carefully structured and run according to a specific risk management strategy in order to garner a triple-A credit rating with a minimum amount of capital. These companies are involved mainly in credit derivatives, such as credit default swaps, but may also transact in the interest rate, currency and equity derivatives markets. Derivative product companies cater mainly to other businesses that are looking to hedge risks such as currency fluctuations, interest rate changes, contract defaults, and other lending risks.
Derivative product companies were created in the 1990s. In many ways, it was the implosion and bankruptcy of Drexel Burnham Lambert, home of Michael Milken, that awakened financial institutions to the credit risk sitting in their derivatives books. When the company went down in 1990, seeing the size and number of counterparty exposures, firms created ratings-oriented DPCs to handle the derivatives books. Financial institutions specifically designed these subsidiaries to have higher credit ratings than the parent entities so they would be able to function with less capital, as the counterparty in any transaction would be less likely to demand collateral be posted when an entity is triple-A. In short, DPCs provided a safer venue for these institutions to perform derivatives transactions as counterparties, often with clients of their parent companies.
Derivative product companies generally use quantitative models to manage the credit risk they are taking on, allocating the necessary capital on a day-by-day basis. Broader market risks are usually hedged by entering mirror transactions with the parent company, leaving the derivative product company with the credit risk. This credit risk is, of course, carefully managed within existing models and guidelines meant to maintain both the overall exposure and the rating of the DPC.
Even with this highly structured environment, a DPC can be hurt. Anything that significantly impacts a DPC’s credit rating will trigger the company’s wind-down, a phase in which the company takes on no new contracts and starts planning its own end by looking at the exposures and timelines left on its books. This happened in 2008 as the financial crisis escalated, which actually illustrated that the risk controls in DPC were far more robust than in some of their parent companies, which were badly scorched by other vehicles they were involved with outside DPCs.