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.