The Trade Lifecycle: Behind the Scenes of the Trading Process, 2nd Edition

Chapter 12 Counterparty Risk Control

As soon as a trade is executed with a counterparty, an exposure to counterparty risk is created. Counterparty risk is when, for whatever reason, the counterparty will not fulfil their contractual obligations. The department concerned with vetting counterparties is generally called the ‘credit risk’ department – not to be confused with credit market risk (ie risk to changes in credit spreads).

12.1 Reasons for non-fulfilment of obligations

The non-fulfilment of the counterparty's obligations manifests itself in non-settlement or delayed settlement. Non-settlement could be because of:

1. Company default

   After executing a trade, the counterparty has ceased to be a trading entity and can therefore no longer settle the trade. This would usually arise because of some legal change of status, such as filing for Chapter 11 of the US Bankruptcy Code or going into administration.

2. Court order

   A court order freezing the company's assets would make settlement impossible.

3. Dispute

   A counterparty might refuse to settle a trade pending resolution of a dispute regarding an individual trade, or because there is outstanding litigation between the two companies involved in a trade, even though it might not be related to that trade.

In these scenarios, absolute non-settlement is unlikely. Some redemption of promised assets is usual, but these would be subject to delay and reduction in amount. For example, a creditor owed money by a liquidated counterparty ...