Counterparty Risk

Every financial contract involves at least two parties. If one of them defaults, the other may suffer losses. Counterparty risk is especially important in derivatives contracts, loans, repurchase agreements and trades that take time to settle.

For example, a company enters into a currency forward contract with a bank to lock in an exchange rate for a payment due in six months. If the bank collapses before the contract matures, the company may lose the protection it was counting on and face a loss if the exchange rate has moved against it.

Counterparty risk became a major concern during the 2008 financial crisis, when the failure of the investment bank Lehman Brothers left many firms unsure whether contracts with it, and with each other, would be honoured.

Counterparty risk is managed in several ways, including assessing the creditworthiness of counterparties, setting exposure limits, requiring collateral, using legal agreements that allow positions to be offset against each other, and trading through central clearing houses. Since 2008, regulators have required many standard derivatives to be cleared centrally, where a clearing house stands between buyer and seller.