Counterparty risk is a term in finance. It means, quite simply, that the party you traded with (the counterparty) won't keep it's end of the deal. When this happens, it will likely cost you money.

With this definition out of the way, let's ask the really important question here:

Do I have counterparty risk?

There are some rather easy rules of thumb. If you just buy shares, futures, options or bonds in the exchange, you don't have counterparty risk. In other words, if you sold your shares to someone who goes bankrupt tomorrow, you still get your money. This is incidentally one of the reasons you pay fees. Of course, you are still exposed to credit risk in the thing you bought: if you bought shares in a company that goes bankrupt, you have typically lost your investment.

So, how do I get counterparty risk? Well, one way of getting it is being a big trading firm, calling another big trading firm, and making a deal without involving the exchange to save costs. If you are a big trading firm, I suppose you are smart enough to work out yourself how to deal with it; if not, well, you won't be a big trading firm for long, so that problem is solved then as well. Another way of getting a very nasty counterparty risk is with so-called structured products. For instance, those funny little investments in which you are guaranteed to get your money back, or 90% of it, and still profit from 50% of the increase in the S&P 500. In the tiny print, it will say "Guaranteed by BNP Paribas". Or "Guaranteed by HSBC". Or "Guaranteed by Lehman Brothers". If you catch my drift.

I have counterparty risk. Am I in trouble?

Well, normally, no. In the vast majority of cases, banks just pay back what they owe you. However, you might still take a loss for two different reasons

The obvious reason is that your bank fails and you don't get paid back. Normally, a large percentage of the value of your structured product is in a liquid asset, like a bond or an index, so it should be possible to sell it and get most of the money out. However, you have no guarantee, and might be left with nothing.

The second reason is more insidious. Imagine you have your structured product, and the rest of the world thinks the issuer may not be able to pay up. Now, if I think I may not get my money out in the end, I'm very inclined to pay less for the product. Maybe not nothing, but less. The market will find an equilibrium price, which may be less than the guaranteed price 1. So, if you sell at this point, you lose money due to your counterparty risk

What is somewhat nasty about counterparty risk is that it is normally close to 0, but can suddenly explode. This makes it easy to ignore and easy to forget, and that is exactly why it is so dangerous: nothing happens, until something happens, and then it's usually catastrophic. Put differently, you know stocks are risky, and you probably keep that in mind when investing, and don't gamble with money you can't miss. Your counterparty getting into trouble is something you might not have considered when investing, and you might lose money you can't miss

In summary, counterparty risk is the risk that your counterparty won't honor his agreement. Normally, this risk is small. Furthermore, trades over the exchange may (this is not always guaranteed) shield you from counterparty risk. However, if you do have counterparty risk, and your counterparty gets into trouble, you might lose a very large amount of money.


  1. Interest (i.e. the fact you won't get your money back in a while) can also cause this to happen.

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