Counterparty credit risk is the risk in a financial transaction involving credit that the party which receives the credit will not fulfill its financial obligations. This is the risk incurred by lenders that the repayment of the loan issued will never be made. As lenders can suffer serious financial damage from defaulted loans, they usually take great care to closely analyze their borrowers' ability to repay their loans. In addition, counterparty credit risk comes into play with derivatives, which are investment arrangements between two parties in which the contract calls for a transaction to take place at some point in the future.
Much of the modern business world takes place by one party issuing some form of credit to another. This means that a borrower can make a purchase or receive a loan while making a promise to pay at some later date. Of course, there is a risk that the borrower will never pay back the loan. This is known as counterparty credit risk, which is a significant concern for lenders of all kinds.
There are ways for lenders to mitigate counterparty credit risk. One way is to have a third party on hand that is witness to the loan arrangement and agrees to mediate the loan process. This method of mediating loans is often used in conjunction with collateral, which is something of value that the borrower offers up as security for the loan. If the loan is not repaid, the mediating third party can step in and claim the collateral on behalf of the lender.
Some lenders wish to offer unsecured loans, meaning that no collateral is offered. As such, these lenders must find alternate ways of lessening counterparty credit risk. The most common way to achieve this is to conduct thorough credit checks on potential borrowers. By knowing the past credit history of a specific borrower, a lender can determine the likelihood of that borrower paying back the loan. A credit check may cause the lender to refuse a loan or to offer one with higher interest payments to balance the risk.
In the world of investing, derivatives are investments that most often bring counterparty credit risk into play. This is because derivatives are usually contracts to make a transaction involving some underlying security at a future date, which raises the possibility that one party won't follow through at the predetermined date. Exchange-traded derivatives, which are traded via a regulatory central exchange, lessen this risk for traders. By contrast, derivatives contracts traded in a so-called over-the-counter market have mediating exchange and therefore incur far more credit risk.