Counterparty Risk

Counterparty risk is the risk that the other party to a financial contract will not meet its obligations, by failing to pay, deliver securities or return collateral, before the contract has been fully settled. It arises in loans, securities lending, repurchase agreements and above all in derivatives, where two firms may owe each other money for years. Banks, dealers, funds and corporate treasurers all manage it, because a profitable trade is worth little if the firm on the other side collapses.

The term overlaps with credit risk but is narrower. Ordinary credit risk concerns a borrower repaying a known amount; counterparty credit risk concerns contracts whose value moves with markets, so the amount at stake is uncertain and can shift from one side to the other. It also differs from settlement risk, which is the shorter exposure during the moment of exchange itself.

Imagine agreeing with a neighbour to split the cost of a new fence next spring. Today nothing is owed. If prices rise by spring, your neighbour owes you more help than expected; if your neighbour moves away or goes broke first, you are left paying the whole bill. The risk is not that the fence is a bad idea, but that the person on the other side of the promise is not there when it is time to pay.

Financial firms make thousands of these promises with each other. To feel safer, they ask for a deposit that grows when the other side owes more, and they often route the promise through a middleman whose only job is to stand behind both sides. Those deposits and middlemen do not remove the risk entirely, but they make a single failure far less likely to spread.

Exposure is what a firm would lose if its counterparty defaulted today, which is the replacement cost of the contract minus any collateral held. Because an interest rate swap or currency forward can swing in value, firms also model potential future exposure: how large the amount owed could become over the life of the trade. Legally enforceable netting agreements allow positive and negative contracts with the same counterparty to be offset, often cutting gross exposure sharply.

A basic way to express the expected cost of default is:

• $\text{EL}$ is the expected loss from the counterparty over the period.
• $\text{PD}$ is the probability that the counterparty defaults in that period.
• $\text{LGD}$ is the loss given default, the share of the exposure that is not recovered.
• $\text{EAD}$ is the exposure at default, net of collateral.

For example, a dealer is owed 50 million dollars on a portfolio of swaps with a fund, after netting and collateral. If the fund's one-year default probability is 2% and 60% of the claim would be lost, expected loss is $0.02 \times 0.60 \times 50{,}000{,}000 = 600{,}000$ dollars. Dealers adjust the fair value of such trades by a credit valuation adjustment (CVA), which applies the same idea across every future date of the contract.

• Collateral and margin. Counterparties post variation margin as values move and, for many trades, initial margin as a buffer against losses while a defaulted position is closed out; a haircut discounts the collateral's value.
• Central clearing. A central counterparty (CCP) becomes buyer to every seller and seller to every buyer, backed by margin and a default fund.
• Limits and diversification. Risk teams cap exposure to any one firm, sector or country and review limits as credit quality changes.
• Credit protection. A firm can buy a credit default swap (CDS) on a counterparty, though this introduces a new counterparty in the protection seller.

The 2008 financial crisis showed how counterparty risk can become systemic. Lehman Brothers filed for bankruptcy on 15 September 2008 with a large book of OTC derivatives, and its counterparties spent years recovering collateral and agreeing claims. The next day the Federal Reserve extended emergency credit to AIG, whose insurance unit had sold credit protection to banks and faced collateral calls it could not meet. Uncertainty over who was exposed to whom caused lenders to pull back from short-term funding markets, including the repo market.

The Basel Committee later estimated that roughly two-thirds of banks' counterparty credit losses in the crisis came from falling CVA values, that is, mark-to-market losses as counterparties' credit worsened, rather than from actual defaults.

At the Pittsburgh summit in September 2009, G20 leaders agreed that standardised OTC derivatives should be cleared through central counterparties and reported to trade repositories, with higher capital for non-cleared trades. In the United States this was implemented through Title VII of the Dodd-Frank Act; in the European Union through the European Market Infrastructure Regulation (EMIR) of 2012. Under Basel III, banks hold capital against both default risk and CVA risk, and margin requirements now apply to many non-centrally cleared derivatives.

Critics note that clearing concentrates risk in a small number of CCPs, which must themselves be supervised closely, and that heavy margin calls can drain cash from firms at the worst moment, as seen during market stress in March 2020.

• Bank for International Settlements: The Basel Framework
• Financial Stability Board