Counterparty Risk
The risk that the other party in a financial transaction fails to fulfill their contractual obligations.
What is Counterparty Risk?
Counterparty risk is the probability that a party in a financial contract — a trading partner, derivatives counterparty, or settlement party — will default on their obligations before the contract is completed. It is particularly prominent in over-the-counter (OTC) derivatives markets, where bilateral contracts (rather than exchange-cleared positions) expose each party to the other's solvency. The 2008 financial crisis highlighted systemic counterparty risk: when Lehman Brothers defaulted, it disrupted thousands of OTC derivative contracts across global markets. Post-crisis reforms, including the Dodd-Frank Act, mandated central clearing of many OTC derivatives to reduce counterparty risk.
Example
When an institutional investor enters into an interest rate swap with a bank, both parties face counterparty risk. If the bank becomes insolvent before the swap matures, the investor may not receive the contractual payments. Central clearinghouses mitigate this by interposing themselves as the counterparty to both sides of the trade, requiring margin collateral and managing default risk centrally.
Source: Bank for International Settlements — Counterparty Credit Risk