Counterparty Risk

What do a share purchase, a deposit with a building society and a loan to a friend have in common, apart from all being transfers of money to another party?....

…. In all cases you are taking on counterparty risk.

All financial transactions involve transferring money between parties (or, to be pedantic, promises of such transfers in given circumstances). The party giving money (the ‘donor’) does so in return for a set of promises or assumptions about money coming back in the future (from the ‘recipient’). The risk that these promises may be broken is ‘counterparty risk’.

Standard financial transactions are usually backed by rules of law and practice that give a country’s support to the recipient’s promises – in effect government guarantees. The strength of these guarantees depends on the strength and alignment of the country offering them.

Counterparty risk often features in offers that seem too good to be true. Such offers are by their nature questionable and you should never take them (Fixed-Sum Game).

If you chose to ignore this advice consider the following:

A standard technique is for a sponsor to take on risks in the transaction chain, get an appropriate price reduction, conceal the risk transfer (or at least not declare it) when passing it to the donor, apparently sweetening the deal with some (but not all) of the price reduction.

A popular source of this illusion is counterparty risk.