Understanding Counterparty Risks & How They Work?

DailyForex.com Team

 

What is a Counterparty Risk? Explained with a Counterparty Risk Example

Every financial transaction requires a buyer and a seller, which become the counterparty to each other. In centralized markets, like equity markets, a clearinghouse collects and ensures each party receives its items. In decentralized over-the-counter (OTC) markets, like Forex, brokers and liquidity providers take over that role. Usually, the process remains smooth and efficient, but what happens when one party fails to deliver? We will explain the importance of knowing the counterparty risk definition.

All You Need to Know About What is a Counterparty Risk

Counterparty risks are the likelihood that one party fails to meet its obligations. Each transaction requires a counterparty for completion. For example, if you wish to buy 5,000 shares in company XYZ, and nobody is selling, the transaction will fail. Imagine you pay for the 5,000 shares, but the seller fails to deliver the share certificates. In equity trading, a clearinghouse collects the funds and shares, ensuring a swift and successful transaction.

While counterparty risk exists primarily in credit, investment, and trading transactions, due to their anonymous and electronic nature, it is essential to understand how to measure counterparty risk.

Centralized markets, like equity markets, and decentralized OTC markets, like Forex, face counterparty risk, but the latter has notably more exposure. Derivative contracts in OTC markets, especially credit default swaps (CDS), have the highest exposure to counterparty credit risk. Credit default swaps occur directly between two parties, spiking counterparty risks, as neither side may have complete details about the financial health of the other.

Understanding How Counterparty Risk Works

When two parties enter into a contract or agreement, counterparty risk exists. The risk depends on numerous factors and the contract structure, but default remains the most visible counterparty risk. It exists in all credit transactions.

What is a Counterparty Risk Example?

Counterparty risk refers to the inability of one party to deliver goods, services, or payments, as stated in a contract. Imagine you place an online order to purchase goods, pay for them, and never receive your goods. Ordering from a trustworthy source will mitigate the counterparty risk.

The most common counterparty risk is default risk. If one party carries a higher risk profile, a risk premium applies. It compensates the other party for the additional risk.

Counterparty Risk Examples

Numerous counterparty risks exist, but the below two examples should present an idea of the concept and help understand the counterparty risk meaning.

Counterparty risk example one - default risk:

  • Bank ABC purchases non-convertible debt from Issuer XZY with a duration of 15 years and an annual coupon rate of 3.00%
  • Bank ABC accepts the counterparty risk that Issuer XYZ fails to make a coupon payment
  • Should Bank ABC want to purchase the debt but considers Issuer XYZ higher risk, a 1% risk premium could apply, taking the coupon rate to 4.00%

Counterparty risk example two - what is counterparty credit risk explained:

  • Bank ABC and Bank 123 enter into an interest rate swap agreement worth $50M
  • Bank ABC agrees to pay a fixed annual interest payment of 4.00%, payable every six months or $1M for a total of $2M
  • Bank 123 agrees to pay semi-annual floating interest payments based on 6-month LIBOR
  • Interest rate swap (IRS) agreements function on netting, meaning only the difference between the 4.00% fixed annual payment and the 6-month LIBOR changes banks
  • If both costs cancel each other, the base case scenario for the IRS, no capital changes banks, and the counterparty risk equals zero
  • Since the floating rate changes daily, the credit exposure changes
  • Bank ABC knows its exposure, as it remains fixed at $1M every six months, but neither bank knows the credit exposure for Bank 123, as it floats
  • Bank 123 must keep capital reserves to cover market and credit default risk, which both parties outline in the initial agreement, with an option to adjust at set intervals

Why Counterparty Risks Matter to Investors

Counterparty risk matters, as it can result in avoidable losses. The 2008 global fiscal crisis and the 2015 Eurozone debt contagion are two examples in one decade which resulted in heavy losses for many market participants. They are examples of credit contagion from counterparty risk, and the most trusted institutions created conditions leading to sharp market sell-offs. Each financial transaction involves a counterparty, and investors must mitigate counterparty risk to lower their overall market risk.

How Can Market Conditions Impact Counterparty Risks?

Global financial markets remain interconnected, and every change, for example, an increase in interest rates or regulatory changes to capital reserve requirements, impacts financial instruments. They can increase counterparty risks, especially for parties with high debt exposure and insufficient capital to meet obligations. Supply chain disruptions can also elevate counterparty risks.

How to Lower Counterparty Risks

Parties can lower counterparty risks, but it is impossible to eliminate them. Some periods and market conditions support lower risk, while others increase them.

Five ways to lower counterparty risks:

  • Deal with trustworthy, well-capitalized, and reliable counterparties
  • Netting lowers the mark to market exposure, as each deal often consists of numerous transactions, and netting only transfers the difference
  • Demanding collateral covering the deal amount entirely or partially
  • Diversification via involving more counterparties, spreading the risk
  • Moving from bilateral trades to centralized venues

What is Necessary to Reduce Counterparty Risks?

Prudent risk management, ongoing risk assessments involving complex calculations and algorithms, and careful selection of counterparties will reduce counterparty risks. Understanding ever-evolving and complex derivative contracts, where most counterparty risks exist, is paramount before engaging in transactions.

What is the Difference Between Counterparty Risk vs. Credit Risk?

Counterparty risk is a sub-category of credit risk and refers to the risk of default or inability to meet contractual obligations. Market participants should not confuse it with default risk, which applies to loans. Below are simplified examples to show the difference.

Loan default risk example:

  • Bank ABC loans $1M to Client XYZ
  • Bank ABC levies interest on the loan, which includes default risk compensation
  • The credit exposure for Bank ABC is $1M unless the loan is secured, in which case the risk drops notably
  • The loan default Bank ABC accepts is approximately $1M, fully funded, and the bank deployed counterparty risk management to lower the risk of loan default exposure
  • Besides secured loans, banks often take insurance policies against select default scenarios and pass the costs on to clients via annual payments, further mitigating credit risks

Counterparty credit risk example:

  • Bank ABC issues a $1M credit derivative, an unfunded bilateral contract, to Bank 123
  • Bank ABC then sells an OTC option to Client XYZ
  • Market risks will move the value of the underlying asset via daily mark-to-market adjustments and impact the option price
  • Bank ABC owes the intrinsic value to Client XZY if Client XYZ ends the option contract in the money
  • They are counterparties to each other, where Client XYZ accepts the counterparty risk that Bank ABC fails to pay
  • Bank ABC faces no counterparty risk, as the option payment settled when Client XYZ purchased it
  • Bank ABC and Bank 123 are also counterparties, where Bank 123 accepts counterparty risks like bankruptcy by Bank ABC, preventing it from fulfilling its obligations
  • Given the daily market moves, the final credit exposure remains unknown
  • Both banks can perform counterparty credit risk management to ensure they engage with a trustworthy party

Counterparty Risks Conclusion

Counterparty risks exist in most financial transactions, most nobly in credit transactions, where default ranks as the primary counterparty risk. Counterparty risk management can lower overall risk, and the best way to mitigate counterparty risks is to deal with a trustworthy and established party. Credit derivatives face ongoing counterparty risks as the value can move in either direction, shifting risks between parties. Trading CDS on centralized exchanges lowers counterparty risks notably, as a clearing firm, or the exchange itself, becomes the counterparty instead of the buyer or seller.

FAQs

Is counterparty risk operational risk?

Operational risk classifies as human risk and is not associated with financial or market risk. It relates to mismanagement and can impact a party from fulfilling its contractual obligations. Therefore, one can consider operational risk as counterparty risk.

Is counterparty risk a market risk?

Market risk is another counterparty risk market participants must consider as it can negatively impact a party's ability to deliver goods, services, or payments. The four primary market risks remain stock price fluctuations, interest rate changes, Forex volatility, and commodity price changes.

How do you assess counterparty risk?

Counterparty risk management helps parties assess counterparty risk. Risk managers also use calculations like credit exposure, expected exposure, and potential future exposure to evaluate counterparty risks. Simulations like the Monte Carlo simulation remain broadly used to assess counterparty risk.

How do you manage counterparty risk?

Dealing with a trusted and financially stable party is the most efficient counterparty risk management tool. Diversifying exposure, hedging exposure, segregating high-risk contracts from lower-risk ones, and adequate capital reserves are paramount to successful risk mitigation.

DailyForex.com Team
The DailyForex.com team is comprised of analysts and researchers from around the world who watch the market throughout the day to provide you with unique perspectives and helpful analysis that can help improve your Forex trading.

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