Counterparty Risk

Counterparty risk is the possibility that your trading partner, broker, bank, or other financial institution will default on their obligations to you.

Where Counterparty Risk Exists:

Derivatives:

• Futures, options, swaps
• Party may not honor contract
• OTC derivatives have higher risk than exchange-traded

Securities Lending:

• Borrower may not return shares
• Collateral may be insufficient

Bank Deposits:

• Bank could fail (FDIC protects $250K)
• Foreign banks may have less protection

Brokerage Accounts:

• SIPC protects $500K (securities)
• Broker failure risk

Types of Counterparty Risk:

Type	Example	Protection
Settlement Risk	Trade doesn't settle	Clearinghouse
Pre-Settlement	Counterparty fails before trade	Credit limits
Delivery Risk	Asset not delivered	Escrow, DVP
Custodial Risk	Custodian fails	Segregated assets

Measuring Counterparty Risk:

1. Credit ratings: Check counterparty ratings
2. CDS spreads: Market's view of default risk
3. Capital ratios: Bank/broker financial health
4. Exposure limits: Maximum per counterparty

Managing Counterparty Risk:

For Individual Investors:

• Use regulated exchanges over OTC
• Stay within FDIC/SIPC limits
• Multiple custodians for large portfolios
• Verify broker financial strength

For Institutional Investors:

• Collateral requirements (margin)
• Netting agreements
• Central clearing
• Credit limits per counterparty

2008 Crisis Lessons:

The Lehman Brothers collapse showed:

• Counterparty chains can cascade
• "Too big to fail" wasn't always true
• OTC derivatives created hidden connections
• Collateral calls accelerated crisis

Post-Crisis Reforms:

• Central clearing mandates
• Higher margin requirements
• Daily marking-to-market
• Improved transparency