Handling counterparty risk in OTC trades

While my primary focus has been to promote the CME Case Shiller home price index futures, there may be situations where the CME futures (or options) don’t satisfy a hedger’s interest in a derivative trade (to differentiate such an inquiry from any loan-based programs).  I’m faced with such a situation now, and could use a reference from someone who may have already dealt with this issue.

I have a trader who’s looking to construct a relatively small put trade where he’d be the buyer and I’d be the writer.  (The index, strike and expiration are important but not germane to this discussion).  In this case, on a put, if he posts the entire put premium, I (the writer) have no credit exposure to him, but he’s at risk to my performing as he- a) doesn’t know me, and yet b) knows that I don’t have the credentials of say, JP Morgan. (This would get more complicated on a forward trade where there’d be two-way credit exposure).

We’ve brainstormed about me putting up collateral against some decline in the index (e.g. if the strike was 200, 20 points for each “lot” using CME options as a template).  I’m OK with posting this much collateral to start as the option is relatively short and interest rates (but not my cost of capital) is near zero.  In addition, I’d like to do the trade as a beta test should any of the larger put inquiries I’ve received move forward.  Net, I can price a return on my capital into the fee that I’ll charge.  The question then is -who do we get to act as a sort of escrow agent for this trade?  The entity would have to be reputable in holding our cash (so most escrow companies) but would have to understand the economics and language (e.g. an ISDA agreement) of a put pay-out.  So far, I’ve stuck out and would love any suggestions.

Note, that since I’m charging my cost of capital, the put price I’d charge would likely be higher that someone else with a healthier balance sheet.  As such, I should be open to flipping (or assigning) the exposure to a highly rated third party.  Let me know if there’s anyone out there who’s conceptually open to writing a 3-6 month put, and who can guarantee performance should the index fall below the strike.

Alternatively, maybe I could get someone to guarantee my performance for a fee that would be lower than my cost of capital.  I’m going to approach my broker to see if that might work.

Finally, while I’ve been working with the CME to consider posting electronic quotes on all ten regional contracts (and I’ve gotten some good feedback on that front) there may be circumstances where a buyer might want to construct a trade referencing another index.

Net, the question of counter-party credit risk exits at institutional levels.   I’d appreciate any insight on how I solve it at my retail level.  Feel free to contact me (johnhdolan@homepricefutures.com) if you’d like to discuss any aspects of this topic.