What is counterparty risk?

Counterparty risk refers to the likelihood or probability that one of the parties involved in a financial transaction may fail to fulfil their contractual obligations. It is also known as default risk.

Counterparty risk exists in various financial agreements and is influenced by many risk factors, including the counterparty’s financial stability, market conditions, and the quality of collateral used.

What is a counterparty risk in corporate finance?

In corporate finance, counterparty risk refers to the potential that the other party involved in a financial transaction may fail to meet their obligations. It is an inherent risk in virtually all financial transactions, including credit, investment, and trading transactions.

Counterparty risk is most often associated with the risk of non-payment, but it can also include the failure to deliver goods, services, or fulfil other contractual commitments. For example, a supplier failing to deliver critical raw materials may disrupt production and negatively impact the company's financial performance.

Counterparty risk can be divided into two categories:

• Pre-settlement risk: This type of risk applies during a transaction, such as a trading partner defaulting before fulfilling their side of an agreement, leaving the other party exposed to potential losses.
• Settlement risk: This involves risks that occur after a transaction is completed. It can be divided into default risk (failure to fulfil an obligation entirely) and settlement timing risk (such as delayed payment or delivery of assets).

For businesses, understanding and assessing counterparty risk plays an important role in safeguarding finances and operations. Various strategies and practices can be used to mitigate this risk, including:

• Performing due diligence to assess the creditworthiness of a potential counterparty.
• Implementing collateral agreements to offset potential losses.
• Diversifying exposure to reduce the impact of one counterparty defaulting.

How does counterparty risk differ from general credit risk?

While sometimes used interchangeably, the concepts of counterparty risk and credit risk are slightly different.

Credit risk is a broader term that considers any potential for financial loss due to a borrower’s inability to meet their financial obligations. It refers to a client’s creditworthiness and is often used in the context of banks issuing loans or corporate bonds.

Counterparty risk, on the other hand, is a subset of credit risk specifically focused on the context of transactions between two parties. It evaluates the probability that one party will fail to meet the terms of an agreement either during or after a transaction (pre-settlement vs settlement risk).

In short, credit risk applies broadly to lending, while counterparty risk evaluates transactional reliability between parties in broader financial arrangements.

What is the significance of counterparty credit risk in B2B transactions?

Counterparty credit risk is an important consideration in B2B transactions because it can directly impact a company's ability to maintain operations and meet its financial obligations.

This risk refers to the possibility that the other party in a transaction – such as a supplier, customer, or partner – may fail to fulfil their financial or contractual obligations, whether that’s making delayed payments, defaulting on loans, or failing to deliver agreed-upon goods or services.

Businesses need to be aware of counterparty credit risk in their B2B transactions as it can have a major effect on their financial stability and operations. For example, if a major supplier fails to deliver materials as agreed, it could halt a company’s production lines and lead to potential losses. Similarly, if a major client defaults on payments it could strain a company’s financial resources and they may be unable to meet their own obligations.

For that reason, many businesses carefully assess counterparty credit risk and apply risk mitigation strategies to maintain cash flow and protect their revenue.

How counterparty risk impacts securities financing transactions

Securities financing transactions (SFTs), such as securities lending or repurchase agreements (repos), involve one party temporarily transferring their assets to another with an agreement to reverse the transaction at a later date. Counterparty risk applies in SFTs because there is the potential for financial losses if one party fails to fulfil its contractual obligations. For example, an investor may fail to return borrowed securities or a firm may not repurchase assets as agreed on.

Some key implications of counterparty risk in SFTs include:

• Liquidity Disruptions: If one counterparty defaults, the other party may experience cash flow disruptions. In some cases, they may need to liquidate assets under unfavorable conditions or seek funding elsewhere.
• Collateral Loss: If a counterparty fails to return collateral or fulfil its obligations, it can lead to financial losses for the other party. This is especially problematic if the collateral's market value depreciates or isn’t enough to cover the losses.
• Market Volatility: If the defaulting counterparty is a major player in financial markets, it could affect the broader market.

To help secure SFTs, firms often employ counterparty risk measures like collateralization, margin requirements, and the use of central securities clearing services to settle trades.

Key methods to mitigate counterparty risk in financial agreements

Below are some different methods companies use to mitigate counterparty risk in financial agreements.

Assess creditworthiness

Before conducting any financial transactions, it’s important to assess the creditworthiness of any potential counterparties. This involves evaluating their financial health and past performance, as well as reviewing credit ratings, financial statements, and market reports for comprehensive due diligence. Even existing counterparties should be regularly monitored to detect changes in risk and allow firms to adjust exposure, collateral terms, or transaction limits accordingly.

Diversify exposure

Another way to mitigate counterparty risk is to diversify exposure across multiple counterparties, sectors, or regions. This can help reduce the impact should a single counterparty default or underperform.

Diversifying exposure can also include balancing a portfolio of assets and liabilities to avoid mismatched maturities, currencies, or interest rates. While this won't directly mitigate counterparty risk, it can strengthen a portfolio so that it’s better equipped to withstand disruptions caused by a counterparty’s default. 

Use collateral and netting

Collateral and netting agreements can also be used to mitigate counterparty risk. Collateral requires one party to pledge assets or securities as a guarantee for a financial contract or transaction. In the event of default, the pledged collateral can be liquidated to cover the defaulting party's obligations and reduce potential losses.

Netting involves offsetting mutual obligations between counterparties by consolidating multiple transactions into a single net payable or receivable amount. This reduces the total exposure and simplifies settlement to minimize the impact of a potential default.

Set risk limits and controls

Risk limits define the maximum allowable exposure or loss for a specific counterparty or portfolio. Risk controls are the processes and mechanisms used to measure, monitor, and manage this exposure. Establishing clear risk limits and controls for financial transactions and contracts can help ensure risks stay within acceptable levels.

Negotiate favorable terms

Strong contractual terms can provide additional security in financial agreements. Key provisions to include are default remedies, dispute resolution mechanisms, and force majeure clauses that can help protect parties in case of unforeseen events or disputes. To remain effective, these terms should be reviewed and updated regularly to align with evolving market conditions, legal standards, and regulatory requirements.

Seek external support

External professionals can provide valuable counterparty risk assessment and risk management solutions. For example, derivatives like credit default swaps can be used to hedge or transfer counterparty risk to another entity.

The role of credit risk assessments in evaluating counterparty risk

Credit risk assessments play an important role in evaluating counterparty risk and helping companies and financial institutions make more informed lending decisions. These assessments involve evaluating a counterparty’s creditworthiness, examining broader market and economic indicators, analyzing financial statements, and measuring the quality and value of collateral to assess a counterparty’s likelihood of defaulting on their obligations.

Credit risk assessments may also include using risk-scoring models and statistical techniques to quantify credit risk, along with stress tests to evaluate the resilience of credit portfolios under adverse conditions. The ultimate goal of these assessments is to provide a comprehensive understanding of potential risks so that institutions can set appropriate risk limits and mitigate the likelihood of unexpected losses.

How do businesses manage counterparty risk in high-value deals?

Businesses can take several measures to manage counterparty risk in high-value transactions. The process often starts by reviewing the counterparty’s financial statements, credit ratings, and market reputation to evaluate their reliability and financial stability. Many firms mitigate counterparty risk by requiring collateral, such as assets or securities, to secure transactions. Additionally, some businesses incorporate a risk premium to compensate for the increased exposure, often in the form of higher interest rates.

What are the challenges of assessing counterparty credit risk?

Assessing counterparty risk is a complex process with several challenges. For example, evaluating a counterparty's creditworthiness often depends on having access to detailed and accurate data such as financial statements or credit reports. However, this information isn’t always readily available, especially for private entities or organizations operating in less transparent jurisdictions.

Creditworthiness can also fluctuate significantly depending on market conditions and regulatory landscapes, which can reduce the reliability of using historical data or past performance as indicators of future behavior. Additionally, credit ratings may not always reflect counterparty’s financial health in real time.

Because of these challenges, organizations often rely on continuous monitoring, advanced analytics, and risk management tools to more effectively manage counterparty exposure.

This material is for informational purposes only and should not be considered as an investment recommendation or a personal recommendation.