Counterparty Risk

Counterparty risk is referred to the risk of potential expected losses that would arise for one counterparty on account of default on or before the maturity of the derivative contract by another counterparty to such derivative contract. The borrower’s credit score helps in the counterparty risk assessment of the creditor or lender.

It is prevalent in all types of transactions when they are undertaken through a centralized counterparty or if the trades are undertaken in the over-the-counter (OTC) market such as credit, trading, and investment-related transactions. However, the quantum of risk is comparatively very high in the case of OTC derivative contracts.

Counterparty risk refers to the likelihood of one of the parties involved in a transaction might fail to deliver their terms or obligations of the contract. It is prevalent in investing, trading, and credit.

Financial institutions, including banks, run a massive position in derivative exposure, which attracts the need for counterparty riskmanagement. This is a significant risk that needs to be well monitored and involves complex computation due to its inherent complexity and multiple factors. It is observable in derivative instruments, which are ever-evolving, adding more to their complexity. Past events have shown this risk to have a catastrophic impact on the global financial markets.

It is also referred to as default risk and is prevalent in almost all forms of credit. However, with counterparty risk, both or all parties entering into a contract must consider the probability of the other party defaulting on their contractual promises and its repercussions.

It is important to note that if one party higher risk of not meeting the terms of the contract, the other party is compensated by a premium in the interest rate. This is referred to as a risk premium.

Most financial institutions and individual lenders look at the credit scores and credit reports of companies and individuals to gauge their creditworthiness and decide if a loan can be extended. All the more, it also has an effect on the interest rate; a higher credit score attracts a lower interest rate, and vice versa.

Let us understand the concept of a counterparty assessment with the help of a few examples. These examples shall give us a practical overview of the concept and its intricacies.

Example #1

ABC Bank invested in the non-convertible debentures of Ray housing finance, which have a maturity of 10 years and pays a semi-annual coupon of 5% per annum. If Ray housing finance fails to make payment of coupon and principal amount, the risk arising from that for ABC Bank is counterparty risk.

Example #2

The Alpha bank entered into an interest rate swap (IRS) agreement with the beta bank to pay a fixed interest of 5% on a notional amount of $ 25 million semi-annually and receive a floating rate based on a 6-month LIBOR.

To account for the risk arising from such an IRS contract, Alpha bank is required to calculate its exposure at default through a method known as the current exposure method, which is based on the maturity of the derivative contract, type of contract (interest or forex contract) and credit rating of the counterparty, i.e., Beta bank and accordingly need to keep a certain amount of capital as provision for the default arising from such counterparty risk.

Let's undertake calculations based on some hypothetical data.

Calculation of Provision for Counterparty Risk by Alpha Bank

Thus 0.38 million dollars is the amount of provision alpha bank will account for the counterparty risk arising out entering into an interest rate swap agreement with the beta bank.

Any transaction across credit, investments, and trade are inevitable to default from time to time. However, to avoid counterparty risk management, financial institutions and private lenders take multiple measures to mitigate the risk. Let us understand how to mitigate this risk through the points below.

• One of the most effective ways to reduce counterparty risk is to trade only with high-quality counterparties with high credit ratings such as AAA etc. This will ensure better CRM and decrease the chances of future losses.
• Netting is another useful tool to reduce this risk. Usually, there are multiple trades undertaken by the financial between them, such as between two counterparties. There may be various; some will have a positive value (MTM gain), and some will have a negative value (MTM loss). By netting such positions, the loss can be reduced drastically, and counterparty risk can be reduced substantially.
• Collateralization is another useful tool to reduce this risk and involves placing high-quality collateral such as cash or liquid securities, reducing net exposure.
• Diversification is another handy tool to reduce, if not necessarily eliminate, the risk. By trading with multiple counterparties, there won’t be a single counterparty with significant exposure, facilitating a single counterparty.
• This risk is to shift from bilateral trades to centralized trades. All transactions are undertaken with a centralized counterparty (such as exchanges and clearinghouses), which eliminate the specific risk but give rise to systematic risk.

The very fact that both or all parties involved in the transaction are exposed to this risk is a testament to its importance and why all parties must conduct their counterparty risk assessment thoroughly. Let us understand other such points through the explanation below.

#1 - Repo Transactions

These are short-term trade agreements between financial institutions, usually secured by liquid collateral securities on which a haircut is applied to mitigate counterparty risk.

#2 - OTC Derivative

As mentioned above, these are bilateral trades between two counterparties and mostly take the form of interest rate swaps (IRS).

#3 - Forex Forwards

Such contracts are usually for more extended periods, involve an exchange of notional amounts, and carry a high amount of counterparty risk.

Both these risks refer to the probability of one party in a transaction or agreement failing to meet their financial or contractual obligations. However, there are differences in their fundamentals and implications. Let us understand them through the comparison table below.

Counterparty risk and settlement risk are two important considerations for borrowers and lenders in the financial, credit, and trading industries. They both relate to potential risks associated with transactions, but they focus on different aspects of the process. Let's discuss each of them in detail through the comparison below.

Counterparty Risk

• Counterparty risk, also known as credit risk, refers to the risk that the other party involved in a financial transaction might default on their obligations.
• This risk arises when one party owes a payment or delivery to another party, and there's a chance that the first party might not fulfill its obligations. This can lead to financial losses, disruptions, and contractual breaches.
• In the context of a derivative contract, if one party is obligated to make a payment to the other party based on the contract's terms, there's a risk that the paying party might not have the funds to honor the payment, leading to financial losses for the receiving party.
• Counterparty risk management can be done through various means, such as conducting credit checks, using collateral, requiring margins, and entering into legally binding agreements.

Settlement Risk

• Settlement risk, also known as delivery risk. It is the risk that one party in a transaction might fulfill its obligations while the other party fails to do so. It leads to an imbalance in the transaction settlement.
• This risk is particularly relevant in cross-border transactions involving different time zones.
• If a bank in a particular time zone transfers funds to another bank in a different time zone for a foreign exchange trade, there's a risk that the first bank might transfer its funds before receiving the funds from the other bank. This could result in the first bank not receiving the intended funds and incurring losses.
• Settlement risk can be reduced through the use of real-time gross settlement systems, synchronized settlement procedures, and coordination between financial institutions.

This has been a guide to what is Counterparty Risk. Here we explain its examples, how to mitigate them, and compared them with credit risk & settlement risk. You can learn more about it from the following articles -

• Check Sheet Definition
• Risk Rating Definition
• Unsystematic Risk Definition
• Political Risk
• Full-Form of LIBOR