Counterparty risk is simply the uncertainty, until a derivatives contract is settled, that one of the participants in a trade will fail to meet their payment obligations.
This is very similar to default risk in loan and bond markets – where the loan or bondholder takes on the risk that the borrower could default and become unable to repay.
What are the risks?
In any transaction there are, at the very least, two participants. These are known as counterparties.
One is the seller, or vendor, in a straight cash transaction. The other is the buyer.
When lending, or writing a derivatives contract, the relationship changes because the transaction takes place over a period of time – in the case of mortgage loans and bonds, over the course of many years.
The broker or writer of a derivatives contract takes the risk that the trader who bought it is able to settle if he is on the losing end of the deal.
Conversely, the trader takes the risk that the broker, or writer, remains in business and is able to pay should the trader end up in the money.
The pricing of the deal should reflect the risk. With the broker, this will be reflected in the amount of margin asked of the trader.
This could be single percentage point to as much as 20% or more. The bigger the percentage the riskier the broker sees the underlying asset.
If the trade goes wrong for the trader, it could swallow up not just the individual investment in that trade but eat into the capital deposited with the broker (the maintenance margin). At that stage the broker will ask for extra margin – a margin call.
That’s the broker’s way of dealing with counterparty risk
Market to market
For the trader, the price of a derivatives deal is marked-to-market. This means that the underlying asset that the derivative product is based on forms the pricing.
If the product is bought through an online platform it is usually linked directly to the live market price of the underlying asset.
Brokers will charge commission, and some will charge a small overnight financing fee for CFDs that run over several days.
Most electronic platforms, however, extract their cut at the spread – that is the difference between the buy price and the sell price.
For example – if I want to buy an asset on a trading platform, that asset might be priced thus: Bid 20 - Ask 24. The bid price is what buyers are willing to pay and the ask price is what the seller is willing accept.
So I would buy at the ask price and the platform pockets the difference. When I sell later at the bid price, the broker again pockets the spread.
The risk here is that a very small pricing change may be swallowed up by the spread
Mitigating the risk
Some brokers continue the practice of buying the underlying asset to hedge the risk.
I buy 100 CFDs in DeltaCorps for £10 expecting the price to rise (for which I pay 5% margin - that's £50, or 5% of 100 x £10).
The broker matches this by buying 100 shares in DeltaCorps at £10 on the stock market, costing a total of £1000.
As a hedge against counterparty risk, this is a sensible idea. If the trade goes the right way for me, I'm in the money, and the broker has made the funds to pay me with gains on his DeltaCorps shares.
If it goes badly for me, and I fail to meet the broker's margin call, he at least has assets to sell – possibly holding them until they are back above £10 each. But not all brokers actually own the assets on which the CFDs are based.
What if the broker goes bust?
Most trading platforms put their capital into a ring-fenced account with a major bank – so even if they go bust, traders’ cash is safe from the demands of other creditors.
In the UK, the Financial Conduct Authority (FCA) must give authorisation for financial services firms to operate. This should be an additional guarantee that your money is safe.
A company regulated by any EU regulator in another EU member country can trade in any EU member state with the same guarantees. The UK’s FCA recognises as equal regulation across the EU.
For so-called "over the counter" deals between large financial institutions, a system of clearing houses have been established in the UK since the financial crisis of 2008.
Here counterparties must put up collateral with a third party that then uses this to maintain any interim interest payments until the deal completes.
Where there's a trade there's risk
There's always a risk that you can lose your money. But weighing up all the other possible risks to your trades, it's more likely any loss of capital will come from the forces of market risk, or from the trading decisions you make, than from counterparty risk.