LONDON: Foreign exchange traders must be considering the practical implications for their counterparty lists if a Moody’s review of 114 European institutions, due by end-June, results in widespread downgrades.

Some banks may lose business, a smaller number could gain. Client exposures and risk may become even further concentrated among a limited number of market participants.

Moody’s recently downgraded the long-term debt and deposit ratings for 26 Italian banks, prompting the Italian Banking Association to call the move an “assault against Italy, its companies and its families.”

The stakes are high.

Banks’ FX desks and other investors have minimum credit rating requirements for their counterparties. If those are no longer met, future transactions may be diverted to better-rated banks, leaving others out of the deal loop.

With 114 names in focus, the review could leave fewer counterparties eligible for even the safest banks to trade with.

Corporate treasurers, real money investors and central bank dealers will be wary of the potential concentration of risk if more trades have to be done with fewer names.

The 2012 Euromoney Foreign Exchange poll shows four banks dominating 48.26 percent of FX transactions. Ten banks accounted for 78.76 percent of the global pie.

Apart from the pressure on finite individual credit lines, too much risk with any single institution is not healthy, especially with the euro zone debt crisis deepening by the day.

It is also a potential headache for the dominant players. They also need to liquidate their positions and if the pool of eligible or willing participants shrinks, that could be problematic.

While not a perfect analogy, seasoned traders of niche currencies may recall how, in the pre-electronic age, the sheer lack of marketmakers meant the intraday spot FX market in those pairs often resembled a gigantic game of “pass the parcel.”

Investors may choose to tweak their credit criteria, perhaps opting to take an average of two or three rating agencies instead of requiring a particular rating across the board.

Others might prefer merely to lower their credit threshold. A double-A rating has effectively become the new triple-A as the universe of top-rated banks has contracted. Perhaps a further lowering of the credit rating bar will be needed.

But there is a limit to how far any investors can compromise their own credit standards.

The risks are not only to future trades.

Banks will be thumbing through their International Swaps and Derivatives Association agreements, which govern forex contracts, to see what Additional Termination Event (ATE) clauses have been written in.

A rating-related ATE would give a counterparty the right to close out existing contracts with a given bank if the bank’s credit rating fell below a certain level.

In the jargon, the counterparty might try to novate the deal — transferring the contract from one party to another by mutual consent of the original parties and of the new one.

There might be a limit to the appetite to take on new trades, presumably by a bank of a higher credit standing, as re-assigning the trade uses up the new party’s credit lines without the chance to make money on the transaction.

Alternatively, the original parties could bring forward the value dates of existing contracts through a process of net present valuing, enabling the contracts to mature immediately.

The better-rated name would no longer have the exposure to the downgraded bank and would probably re-create a similar trade to replicate the original exposure, albeit risking the market moves in the meantime, with a higher rated entity.

It is easy to see why a better-rated party might prefer to tweak his credit policies to avoid going to all this trouble.

But even if they adopted that stance, they might not be willing to conduct as high a share of their future trades with the downgraded institutions.

No one in the foreign exchange market should be under any illusions. If widespread credit rating downgrades follow the Moody’s review, there will be knock-on effects to actual trading relationships. It might not be a pretty sight for many banks.

— Neal Kimberley is an FX market analyst for Reuters. The opinions expressed are his own.