A counterparty is the opposite party in a financial transaction. This means that both parties in a transaction can be referred to as a counterparty.
The term counterparty can refer to any entity on the other side of a financial transaction. This can include deals between individuals, businesses, governments, or any other organization. Additionally, both parties do not have to be of equal standing regarding the type of entities involved. This means an individual can be a counterparty to a business and vice versa. In any instances where a general contractor is met or an exchange agreement takes place, one party would be considered the counterparty or the parties are counterparties to each other. This also applies to forward contracts and different contract types.
Entering into a contract with a counterparty generates what is known as counterparty credit risk.
Credit risk is the possibility that the counterparty to a transaction may not fulfill their obligation to set the transaction successfully.
One of the most common counterparty risks is payment default, the inability to pay outstanding amounts when due.
This risk is often eliminated by using a Central Counterparty Clearing House.
This third-party intermediary assumes the credit risk of both counterparties and identifies what is needed from each counterparty to complete the transaction successfully.
For example, as counterparties, the purchaser, and the supplier of a product are often unknown to each other, a clearing house can be essential to reduce counterparty risk significantly.
A counterparty introduces counterparty risk into the equation. This is the risk that the counterparty will be unable to fulfill their end of the transaction. However, in many financial transactions, the counterparty is unknown, and the counterparty risk is mitigated through clearing firms. In fact, with typical exchange trading, we do not even know who our counterparty is on any trade, and often there will be several counterparties, each making up a piece of the work.