In simpler terms, it’s the risk that the party you’re engaged in a financial transaction with will be unable to meet their contractual obligations. This could happen due to financial difficulties, insolvency, bankruptcy, or other factors that might prevent them from honouring their commitments.
For example, in a loan transaction, counterparty risk would be the risk that the borrower might not be able to repay the loan. In a derivative contract, it could be the risk that one party may not be able to deliver the underlying asset as agreed.
Counterparty risk is a crucial consideration in financial markets, and institutions take various measures to mitigate this risk. These may include conducting credit assessments, requiring collateral, using credit derivatives, and setting up clearing houses for certain types of transactions.
During the 2008 financial crisis, counterparty risk played a significant role, particularly in the collapse of major financial institutions and the subsequent global financial turmoil. This event highlighted the importance of understanding and managing counterparty risk in the financial industry.