What Does Counterparty Risk Mean?
Investopedia explains Counterparty Risk
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Counterparty risk. Counterparty risk is the risk that the person or institution with whom you have entered a financial contract -- who is a counterparty to the contract -- will default on the obligation and fail to fulfill that side of the contractual agreement.
In other words, counterparty risk is a type of credit risk. Counterparty risk is the greatest in contracts drawn up directly between two parties and least in contracts where an intermediary acts as counterparty.
For example, in the listed derivatives market, the industry's or the exchange's clearinghouse is the counterparty to every purchase or sale of an options or futures contract. That eliminates the possibility that the buyer or seller won't make good on the transaction.
The clearinghouse, in turn, protects itself from risk by requiring market participants to meet margin requirements. In contrast, there is no such protection in the unlisted derivatives market where forwards and swaps are arranged.
So how I understand Counterparty Risk is this, there's a risk that one entity will default on their end of a promise. I could come up with an example like this....
I loan my car to a friend for a week, and in return they promise to give it back to me in the same condition, and with a full tank of gas. They also promise to give me an extra $100 (like a rental fee) for the use of my car. We are both taking on risk in this situation called Counterparty Risk. I risk that my friend will damage my car, bring it back with less than a full tank of gas, not bring it back in a week, or not give me the $100. My friend risks the fact that I could need my car back in less than a week and take it back.
If either of us default on our promise, we open up a whole new can of worms on determining what the repercussions would be. If I need to take my car back in 3 days, but my friend went to Las Vegas, we have a new problem because I can't get my car back. So I need to "default" on my friend, but by defaulting, I create many more problems that need a resolution.
In the same way, if my friend takes my car and either damages it or doesn't bring it back in a week, we have problems again that need to be resolved. I need a new car, we need to work out an arrangement for damages or loss of use, etc. Sometimes what happens can be easily resolved, other times it can't and it's much more complicated. So the lesson on Counterparty Risk is, it's always there when you make an agreement for things. You expect that the agreement will be kept as is and nothing will come up to change that agreement. But inevitably things always could come up.
So I want to take this one step further as it'll help some explanation later. Let's say that I make an agreement with my friend as stated above. As far as I know, he's driving the car for a week. Well what if my friend borrows my car that's a Ferrari. It's a sweet ride and it's the envy of all of his friends. They also want to borrow the car for a day during the week. Well my friend then lends out my Ferrari to 3 other people on different days at a higher lending rate and makes the money to easily cover the cost of the gas and the $100 he owes me and turns a profit. Then on each day his friends also lend the car to some of their friends for an hour each day to help cover the cost of them borrowing the car. I would call this leveraging, and it greatly increases the Counterparty Risk because now there's not just me and my friend, but now three of his friends borrowing the car for a day (5 friends) and three of their friends borrowing the car for an hour each day (11 people involved in total). Each friend is leveraging the one car to 11 people. And each friend now has created additional Counterparty Risk. If any of those people default on their agreement, we could have a Systemic Risk of all of our agreements failing and tons of things needing to be sorted out among all of us.
So what does this have to do with money?
Well, this is the situation that has occurred over the past 3 years, but on a much larger scale involving our entire financial system. In 2008, when Bear Sterns went bankrupt, it was as if there was a default in me loaning my car to my friend. We were able to resolve it just like Bear Sterns went bankrupt and got bought out by JP Morgan, and all was well. Then Lehman Brothers went bankrupt a few months later. Let's compare their bankruptcy to my friend lending my car to one of his 3 other friends for a day. If that default happens, the solution is a lot more complicated. The same was when Lehman Brothers went bankrupt, it created a whole bunch of more problems. It brought in AIG into the mix as the insurer.
This would be the equivalent of say my friend buying insurance to protect himself in case of his friends defaulting on their daily agreement causing great problems for himself and our weekly agreement. In this sense, in the financial world, I would call it a Credit Default Swap. Only in the financial world, they are lending money, not cars. And it was this that caused AIG to almost go bankrupt because they had to pay back all of the defaults that Lehman Brothers among others were causing during the 2008 crises.
Hopefully now you are beginning to see the much bigger problem in the financial world. Things are developing every single day to further us down the path. The problem is, when you're dealing with money in the financial world, Credit Default Swaps, Derivatives, leverage of assets, lending of securities and the mass amounts of Counterparty Risk between all involved, it becomes a Systemic Risk of the entire financial system collapsing.
2008 was about one part of the financial system, namely the real estate market and mortgages causing problems. The original agreements caused a chain reaction through out our system as the bank who lent money to people for homes started to default, causing the banks to sell and remove liquidity from the leveraged system, causing more deleveraging of other companies until one couldn't get the liquidity it needed and failed (Bear Sterns, Lehman Brothers).
So liquidity is a big concern right again right about now. It was the reasoning, I think, behind the reduction in the swap lending rates last week that took us out of the dire situation we were in and bought a week or so until this week. But things are brewing again just like in 2008, only the situation is a whole lot bigger this time. The Dow Jones and the rest of the market are just outward reflections of the liquidity and money flows around the world. When there's issues, like what's going on in Europe right now with liquidity, it gets reflected in the stock market. So when I post a chart like the Dow that I've been following for the past month, and all of the other charts look the same way, there's underlying problems. Problems like 2008's credit crisis don't happen very often. So to compare a chart to 2008 is saying a lot, because that crisis brought the US and the rest of the world to it's knees for a couple weeks.
But think of right now as if all of the friends have bought insurance against something happening as far as loaning the car to each other because now they learned from the first time they had problems. So they are all insured and have somewhat of a game plan in case one of the friends defaults on their agreement, only this time there's no longer a problem with the loaning of the car among friends, there's a problem with the car itself. That's where I think we are today and why the similarities are there just like 2008, only much different.
More later...
Because A is a counterparty to B and B is a counterparty to A both are exposed to this risk. For example if Joe agrees to lends funds to Mike up to a certain amount, there is an expectation that Joe will provide the cash, and Mike will pay those funds back. There is still the counterparty risk assumed by them both. Mike might default on the loan and not pay Joe back or Joe might stop providing the agreed upon funds.
In most financial contracts, counterparty risk is also known as "default risk".
The risk to each party of a contract that the counterparty will not live up to its contractual obligations. Counterparty risk as a risk to both parties and should be considered when evaluating a contract.
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