Counterparty risk is the risk that a one party to a contract will not meet its contractual obligations, whether they are unable, or simply unwilling, to do so. This could include failure to repay a deposit of cash, to settle an invoice or to supply goods when due. It is not necessarily purely financial.
Credit risk is the risk that a counterparty will not settle an obligation for full value, either when due or at any time thereafter. In exchange-for-value settlement systems, the risk is generally defined to include both replacement cost risk and principal risk.
This is also called ‘default risk’. It also refers to how much of the contract is performed. In some defaults, all the amounts at risk might be received (for example, in a secured lending), or just some might, or indeed none at all. The total amount of funds lost is known as ‘loss given default’.
In the following blog the author looks at some of the different types of counterparty risk and considerations in each case to manage these risks.
The Unpredictable Vendor
Imagine you're running a manufacturing company, heavily reliant on a single vendor for critical components. One day, you receive a call—your vendor is facing supply chain difficulties and can't fulfil your next order. Your production grinds to a halt, and panic sets in. This is a classic case of concentration risk.
Diversification is key here. By spreading your business across multiple vendors, you reduce the impact of one vendor's failure. It might seem like more work initially, but it's a safety net that can save your business from significant disruptions. Think of it as not putting all your eggs in one basket.
The Overextended Customer
Now, picture this: you have a customer who places large orders regularly, contributing significantly to your revenue. But one quarter, they start delaying payments. You dig deeper and find out they're struggling financially. If they default, your cash flow could take a serious hit.
One way to transfer this risk is by using letters of credit. When your customer’s bank guarantees their payment, you're protected from their potential default. Additionally, credit insurance can cover you against the risk of non-payment. By transferring this risk to a more creditworthy entity or an insurance provider, you safeguard your revenue stream.
The New Market Dilemma
Your business is thriving locally, and you're considering expanding into a new geography. A new market offers great potential but comes with untested vendors and customers. Is it worth the risk?
This is where thorough due diligence and analysis come into play. Conducting comprehensive research on the new market and potential partners can reveal risks that might not be immediately apparent. Sometimes, the best strategy is to avoid risks altogether if they outweigh the potential rewards. It's better to be safe than sorry.
Staying Vigilant
Beyond these strategies, always be aware of your counterparties’ financial positions. Regularly conducting due diligence and keeping an eye on their financial health can help you spot trouble before it affects you. Additionally, stay informed about economic and geopolitical risks that could impact your partners. Economic downturns or geopolitical tensions can increase the likelihood of defaults and other financial issues among your business partners.
Conclusion
Managing credit and counterparty risk is like navigating a ship through turbulent waters. By diversifying your partners, transferring risks to more secure entities, conducting thorough due diligence, and staying vigilant, you can steer clear of potential disasters. In an unpredictable economic environment, these strategies will help you maintain stability and ensure long-term success. Trust is essential in business, but so is protecting your business interests.
Further reading:
Counterparty risk article: Whilst written a while ago, the content in the following article is still relevant and looks at two major factors affecting counterparty risk. Firstly, the creditworthiness of banks as they are no longer seen as incapable of failure. Secondly, the rise in cash holdings by many of the world’s corporations (both large and small) as they hold back on capital expenditure in an uncertain economic environment and protect against future liquidity risk. Read the article.
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This blog was written by Kortam Mohamed who is a member of the Future Leaders in Treasury working group. To find out more about the group please visit the Future Leaders in Treasury webpage.