Counterparty credit risk, also referred to as just counterparty risk is a subset of credit risk, and is the risk of loss from one party in a financial markets transaction not meeting their obligations to the other party or counterparty in the transaction.
With regular lending risk a bank or bond investor will know how much they might lose if the loan they've issued or the bond they hold defaults, that being the fixed amount of money due to be repaid on the maturity date or the redemption value of the bond.
But for counterparty credit risk, the size of the potential future loss is much harder to estimate since how much is owed by the other counterparty, if anything at all depends on market conditions at the time when the counterparty defaults.
Counterparty risk is especially prevalent in over the counter transactions, often involving derivative contracts.
This is because notional values of derivative contracts are often very large, meaning the potential losses that could be suffered on the transaction can also be large, and these losses will require financing in the future when the derivative is due for settlement.
In addition, there is often no central counterparty, which can often be referred to as a clearinghouse, protecting the two counterparties to an OTC or over the counter derivative trade.
Counterparty credit risk can also be present with exchange traded derivatives, but this risk is typically low due to the collateral held by clearing houses who are the counterparty to every trade entered into over a derivatives exchange.
Securities financing transactions involve investors using assets as security for funding such as repo transactions, margin lending, or stock lending, and these also carry counterparty credit risk.
Since the replacement cost of a transaction that's not honored will not be known before the breach of contracts occurs.
Counterparty credit risk can be further broken down into settlement risk and pre-settlement risk.
Settlement risk is the risk the counterparty defaults during the settlement process when the amounts owed have been calculated, but one counterparty fails to deliver on the required date.
Pre-settlement risk is the risk that a counterparty will default prior to the expiration date of the contract.
In other words, prior to the final settlement of the transaction when money was due to be paid.
