What is a Counterparty Risk?

Counterparty risk is the risk that a party to a transaction does not comply with the terms of the contract. Transactions may involve the delivery of cash or the transfer of physical assets. The liquidity risk involved in delivery risk refers to the ultimate performance of the counterparty, but not at the time agreed in the contract. Therefore, a transaction party that fails to recover the funds on time must make up this funding gap. ^[1]

Counterparty risk

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Counterparty risk is the risk that a party to a transaction does not comply with the terms of the contract. Transactions may involve the delivery of cash or the transfer of physical assets. The liquidity risk involved in delivery risk refers to the ultimate performance of the counterparty, but not at the time agreed in the contract. Therefore, a transaction party that fails to recover the funds on time must make up this funding gap. ^[1]

But compared with the general credit risk, the counterparty risk of the credit derivative itself is smaller. This is because the counterparties to credit derivatives may be first-rate

A counterparty is a party with which a transaction is done. If A sells something to B, then B is a counter-party from A's point of view and vice-versa.

The risk that the counterparty will fail to fulfil their obligations-usually either by failing to pay or by failing to deliver securities-is called counterparty risk.

There are a number of ways of controlling counterparty risk. Some are trading mechanisms such as DVP or the use of a central counterparty.

Financial institutions should track and manage counterpart risk in much the same way as any other credit risk, and this should be integrated into institutions' overall risk management system.

The counterparty risks from securities trading are either simple credit risks (where the risk is that the other party will not pay) or a combination of credit risk with the risk of a position in a derivative (where the risk is that the other part will not deliver securities).

Counterparty risk tends to be at least as much of a concern to regulators as to the institutions exposed to it. This is because a large financial institution will be a counterparty to many others, and therefore the knock-on effects of its failure pose a systemic risk.