Counterparty Risk — The Risk That the Other Side Can't Pay
Even if your judgment is right, if your counterparty can't pay, your gain evaporates. This 'risk that the other side can't keep its promise' shook global finance in 2008.
What is counterparty risk
Counterparty risk is the risk that the other party to a transaction fails to fulfill its contractual obligations (default).
Put simply, it's the risk that 'even if you're right, it's useless if the other side can't pay.' For example, in a derivatives contract, you may have won and be owed money, but if the counterparty goes bankrupt, you won't receive that gain.
This risk is especially large in the following situations: (1) OTC derivatives (contracts not routed through an exchange) (2) Securities lending (the risk of lending out shares and not getting them back) (3) Assets held with an exchange or intermediary
In other words, counterparty risk exists in every moment where your assets or gains depend on someone else's creditworthiness.
2008 Lehman Brothers — When the other side collapsed
The classic case in which counterparty risk shook the world is the 2008 Lehman Brothers bankruptcy.
With total assets of about $639 billion, Lehman marked the largest bankruptcy in U.S. history. The problem was that Lehman was entangled with financial institutions worldwide through roughly 906,000 derivatives trades with a notional value of about $35 trillion.
When Lehman collapsed, the many institutions that had traded with it could no longer collect what they were owed. One firm's bankruptcy spread into losses for its counterparties, and those losses passed on to yet others, so that the fear that 'no one knows who will fall next' froze the entire market.
This is the classic path by which counterparty risk spreads beyond an individual risk into systemic risk.
'Lehman's total assets of about $639 billion (the largest U.S. bankruptcy)' and 'about 906,000 derivatives trades with a notional value of about $35 trillion' were cross-checked against Wikipedia and Yale EliScholar (Journal of Financial Crises).
Mechanisms that reduce the risk, and their limits
There are several mechanisms to reduce counterparty risk.
(1) Central counterparties (CCPs): the exchange guarantees settlement in the middle, so that even if one side fails, the other side takes less of a loss. (2) Collateral (margin): collateral is posted in advance to cover potential losses. (3) Depositor/investor protection schemes: bank deposits or some securities assets are protected up to a limit.
But these mechanisms are not almighty either. In the bankruptcy of a crypto exchange like FTX (2022), customers' entrusted assets themselves were not returned.
In the end, the soundness of your counterparty — 'whom you entrust your assets to and whom you trade with' — matters as much as the return.
Frequently Asked Questions
Q. Are counterparty risk and credit risk the same thing?
They overlap but have different nuances. Credit risk mainly refers to 'the risk that the party you lent money to (a bond issuer, etc.) can't pay,' while counterparty risk broadly refers to 'the risk that the other party to a trade or contract fails to fulfill its obligation.' It appears in every relationship where your gain or assets depend on the counterparty's creditworthiness — derivatives trades, securities lending, exchange custody, and so on.
Q. Is it safe to entrust my assets to an exchange?
Regulated exchanges have multiple safeguards, but there is no 'absolute safety.' Especially at some lightly regulated crypto exchanges, entrusted assets were not returned, as in the FTX case. It's important to check the soundness, level of regulation, and whether client assets are held separately at the institution you entrust your assets to.
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