Which of the Following Are Sources of Counterparty Risk?

Every financial transaction involving two parties carries some level of risk that one side may fail to meet its obligations. This is known as counterparty risk, which appears in various banking, investing, and trading activities. Understanding its sources is essential for managing exposure and preventing losses.

Unsecured Loans

Lenders extend unsecured loans without requiring collateral, relying solely on the borrower’s creditworthiness. This increases counterparty risk because no asset backs the loan that can be seized in case of default. Banks and other lenders assess this risk by reviewing credit scores, income, and debt-to-income ratios.

Credit cards, personal loans, and corporate bonds are common examples. Credit card issuers risk cardholders missing payments or declaring bankruptcy, leaving balances unpaid. Investors in corporate bonds face the possibility that the issuing company may fail to meet interest payments or repay principal at maturity. Junk bonds, which are below investment grade, carry an even higher probability of default.

To offset this risk, lenders charge higher interest rates on unsecured loans. A borrower with a low credit score may receive a personal loan with an APR exceeding 30%. Banks also diversify loan portfolios to spread potential losses rather than concentrating risk in a few high-risk borrowers.

Derivatives Trading

Derivatives are contracts whose value is derived from an underlying asset, index, or rate. They are used for hedging, speculation, and portfolio enhancement. Exchange-traded derivatives benefit from clearinghouses that act as intermediaries, but over-the-counter (OTC) derivatives expose participants to counterparty risk because transactions are privately negotiated.

This risk is particularly significant in credit default swaps (CDS), interest rate swaps, and currency forwards, where large sums are involved. During the 2008 financial crisis, AIG faced severe liquidity issues due to its CDS exposure, nearly collapsing before receiving a government bailout.

To mitigate this risk, market participants require collateral, known as variation and initial margin, to cover potential losses. The International Swaps and Derivatives Association (ISDA) has established standardized agreements, such as the ISDA Master Agreement, which outlines the rights and obligations of each party, including provisions for netting and collateralization. Netting allows firms to offset gains and losses across multiple contracts with the same counterparty, reducing overall exposure.

Margin Lending

Investors seeking to amplify market exposure use margin lending, where brokerage firms extend loans using securities as collateral. This allows traders to purchase more assets than their cash balance would permit, increasing potential returns but also introducing counterparty risk. If pledged securities lose significant value, the borrower may struggle to meet margin calls, exposing the lender to losses.

Brokerages manage this risk by imposing maintenance margin requirements, which set minimum equity levels investors must maintain. If an account’s equity falls below this threshold, the firm issues a margin call, requiring the investor to deposit additional funds or liquidate holdings. Failure to meet these demands may result in forced selling of securities, which can exacerbate market volatility. The Financial Industry Regulatory Authority (FINRA) enforces a minimum maintenance margin of 25%, though firms often set higher requirements.

In volatile markets, rapid price swings can lead to situations where liquidating collateral does not fully cover outstanding debt, particularly in leveraged positions on speculative stocks. This was evident in the 2021 collapse of Archegos Capital Management, where excessive leverage led to multi-billion-dollar losses for counterparties, including major banks.

Repurchase and Reverse Repo Deals

Short-term liquidity needs in financial markets are often met through repurchase agreements (repos) and reverse repos, which involve the sale and subsequent repurchase of securities at a predetermined price. These transactions function as secured short-term borrowing, with the seller agreeing to buy back the securities at a slightly higher price, reflecting the interest cost of borrowing.

The risk in a repo transaction arises if the seller defaults before repurchasing the securities, leaving the cash lender exposed. This is particularly concerning when the collateral depreciates sharply, potentially resulting in a loss even after liquidation. To mitigate this, counterparties apply a “haircut,” reducing the amount of cash lent relative to the collateral’s market value. For instance, a 5% haircut on a $10 million Treasury bond means the lender provides only $9.5 million in cash, creating a buffer against price fluctuations.

Securities Lending

Financial institutions, hedge funds, and institutional investors engage in securities lending to facilitate short selling, enhance portfolio returns, or meet collateral requirements. In these transactions, the lender temporarily transfers securities to a borrower in exchange for collateral, typically cash or high-quality assets.

A major risk arises when the collateral is reinvested in assets that decline in value, leaving the lender vulnerable if the borrower defaults. This issue became evident during the 2008 financial crisis when some institutions suffered losses from reinvesting collateral in illiquid or distressed securities. To mitigate this, lenders often require overcollateralization, meaning borrowers must post collateral exceeding the borrowed securities’ value. Daily mark-to-market adjustments ensure collateral levels remain adequate in response to price fluctuations.

Guarantees and Letters of Credit

Businesses and financial institutions use guarantees and letters of credit to secure transactions and financing. These instruments serve as commitments by a third party—usually a bank or insurer—to cover obligations if the primary party defaults.

Letters of credit are commonly used in international trade, ensuring that exporters receive payment even if the importer encounters financial difficulties. However, if the issuing bank becomes insolvent, beneficiaries may struggle to recover funds. Similarly, corporate guarantees, often provided by parent companies to support subsidiary obligations, can become worthless if the guarantor faces financial distress. Counterparties assess the creditworthiness of the issuing institution and may require additional security, such as standby letters of credit or escrow arrangements.