Quick definition Counterparty risk is the risk that your trading counterparty fails to deliver. You execute a buy order but the seller doesn't deliver the securities. You execute a short sale but can't return the borrowed shares. What it is When you trade, you assume counterparty risk: the risk that the other party will default. This risk is mitigated by clearinghouses (which guarantee settlement) and by collateral requirements (margin). Counterparty risk is significant for: - OTC derivatives (not centrally cleared) - Credit agreements - Securities lending - Forward contracts Why it matters Counterparty risk can cascade through financial systems. The failure of Lehman Brothers in 2008 created counterparty risk for all firms that had exposure to Lehman. Counterparty risk is a major consideration in pricing. Risky counterparties must pay higher rates or provide more collateral. Central clearing Central clearing (through a clearinghouse) eliminates bilateral counterparty risk. The clearinghouse becomes the counterparty to both sides and guarantees settlement. Most exchange-traded derivatives are centrally cleared. OTC derivatives can be cleared through central clearinghouses or remain bilateral. Credit rating and counterparty risk A counterparty with a lower credit rating poses higher counterparty risk. Banks price this into the cost of derivatives. During crises, credit ratings can change suddenly, creating unexpected counterparty risk. Practical example You enter a 5-year interest rate swap with a major bank. The bank defaults mid-contract. You are exposed to whatever the replacement swap would cost and lose any profits from the position. If the swap had been centrally cleared, the clearinghouse would guarantee the swap and you would only face replacement cost, not default risk. Mitigation Counterparty risk is mitigated by: - Central clearing - Collateral (margin) - Credit agreements - Stress testing and limits - Diversification across counterparties See also - Credit Risk - Clearing - Systemic Risk - Central Clearinghouse
