Counterparty credit risk managers have a number of tools to help mitigate counterparty risk.

The first way to manage counterparty risk is to only trade with high quality counterparties with strong credit ratings.

This will result in having exposures to counterparties who are less likely to default.

Netting is another useful tool to reduce counterparty risk.

Usually participants in the wholesale financial markets will have multiple open trades with many counterparties at any point in time across the many activities and trading desks within their organization.

By marking-to-market regularly, which means daily for most banks, the full extent of any position and the degree to which they may be offsetting, meaning the exposures can be netted off, can be determined and analyzed so that the bank is fully aware of the true exposure that they face.

Awareness of the size of the risk faced allows risk managers to take correcting action if this exposure is above the level that the bank is willing to tolerate.

Collateralization is a critical tool to reduce counterparty risk.

This involves counterparties providing high quality collateral such as cash or liquid securities to be held against any loss making positions of the counterparty.

These assets will be used to meet any unpaid obligations in the future if necessary. Banks may hedge their counterparty risk with derivative contracts such as credit default swaps.

This can be expensive and may also remove the prospects of any gain that would be associated with future favorable market movements.

Next risk can be reduced through diversification of counterparties by trading with multiple counterparties, counterparty risk is likely to be lower since it is unlikely that all counterparties will default at the same time, meaning that any exposure to a single counterparty will be relatively small in relation to the entire risk faced by the bank.

And if one counterparty were to default, the impact on the bank would be more limited than if trades were entered into with a smaller number of bigger counterparties.

Large banks and institutions typically use standardized agreements for netting and collateral based on a template produced by the International Swaps and Derivatives Association or ISDA.

Streamlining the process of getting legally binding documentation in place between counterparties and thereby reducing counterparty risk.

Finally, using centralized clearing wherever possible will substantially reduce counterparty risk since it will be in the main transferred to the clearing house.

Since the 2008 global financial crisis, a number of regulators have mandated that some forms of standardized interest rate swaps and credit default swaps are centrally cleared where this is possible.