Definition
Counterparty Risk
Counterparty risk is the danger that the other party to a financial contract fails to meet its obligations, especially relevant in over-the-counter derivatives and forwards.
When two firms transact directly (over the counter) in a forward or swap, each bears the risk the other defaults before settlement. The 2008 collapse of Lehman and near-failure of AIG made counterparty risk central to global finance.
Exchange-traded products reduce this risk through a clearing corporation that guarantees both sides. India's exchanges (NSE, BSE, MCX) use clearing corporations and margining so traders face the clearer, not each other, sharply cutting counterparty risk versus OTC deals.
Related terms
- Clearing CorporationA clearing corporation is the entity that clears and settles trades on an exchange, becoming the buyer to every seller and the seller to every buyer through novation, and guaranteeing settlement.
- Currency Swap (FX Swap)An FX swap is a simultaneous agreement to buy a currency at the spot rate and sell it back at a forward rate (or vice versa), used to manage short-term funding and liquidity.
- Credit Default Swap (CDS)A credit default swap is a derivative that pays out if a borrower defaults, functioning like insurance on a bond and whose price reflects the market's view of default risk.
- MarginMargin is the upfront money a trader must keep with the broker as collateral to take a leveraged futures or options position, set by the exchange to cover potential losses.
Plain-English explainer from The Dispatch Investors Encyclopedia. General information, not financial advice.