Counterparty risk definition
Counteparty risk illustrated with two examples
Counterparty risk is well known by every entrepreneur. If you are a small manufacturer and you deliver a piece of machinery to a client, this client typically has 30 or 90 days to settle the purchase. If the client unfortunately defaults during that settlement period, he will keep the machinery, and you will be added to the (long) list of creditors. It will probably take several years for the client to emerge from bankruptcy, and for you to recollect the proceeds of your sale. Most likely, you will not be made square, receiving instead only a fraction of what it has cost you to produce the equipment.
By then, you, the entrepreneur, may also be bankrupt.
The same issue exists in market finance, where every entity has a probability of default. If you purchase a derivatives and it appreciates during its lifetime, you really hope that your counterparty will be able to pay for its settlement.
Here is an example of such a counterparty risk in the financial markets.
- Let’s say that you bought a barrel of oil at $20, with a 3 month settlement. That’s a 3-month forward.
- During those three months, an oil embargo starts, and your barrel goes from $20, to $30, to $50 and reaches $100 at the forward’s expiry date.
- If the contract is “cash-settled”, your counterparty must pay you $80. If the contract is “physical”, and your counterparty doesn’t have that barrel already, he must pay $100 to buy that barrel somewhere the market, and re-sell it to you at $20.
- At that stage, you really hope that your counterparty doesn’t default. First, because you really counted on that $80 profit to materialize (you have already declared the income), but, second, because you may have another derivatives against the forward, and you probably owe that $80 to somebody else. You really don’t want to be between a rock and a hard place… If your counterparty defaults, you maybe in a serious bind as well.
Definition of counterparty risk
Counterparty risk is the risk that you don’t get paid by your counterparty on a contract favorable to you, usually because your counterparty becomes insolvent.
Major financial players (broker dealers, investment funds…) usually protect themselves against counterparty risk in their OTC contracts with these three main tools: risk limits, collateral and provisions/capital.
1. They limit the amount of risk/notional/exposure with every counterparty, based on these firms’ overall financial strengths and the market conditions. A trader must therefore check if he has “enough credit line” available with a given counterparty before engaging in a trade. Those limits are constantly monitored and strictly enforced. Trading without checking/having an appropriate credit is a fireable offence.
2. Firms monitor the amount they are owed and ask counterparties to post collateral as soon as the market value of trades increases. It is now Business As Usual to have this collateral management process integrated in the contracting process. It is actually an integral part of the ISDA master agreement framework.
3. Finally, firms have to put capital aside, in line not only with the market value of current trades, but now also with the probabilities that the market values of these trade increase, and impact the trade price accordingly.