As a market participant ends a trade. They're not just interacting with abstract numbers or isolated assets. They're entering into a relationship with another party, a counterparty. Ensuring the reliability and integrity of this relationship is where counterparty checks and limits come in. Before any transaction, it's paramount to assess how trustworthy the other party is, or in other words, what is the counterparty credit risk.

This can be gauged through credit ratings given by agencies like Moody's or S&P. Think of these as report cards for financial entities with grades indicating their likelihood of default or their facing financial hardships in the future. It's never prudent to put all your eggs in one basket, and similarly, investors or institutions will set caps on how much exposure they'll take on with any single entity, even for those with extremely low counterparty credit risk. For instance, a bank might have limits on how much they loan to other institutions or even to the government, or a fund might cap its derivative exposure to a specific counterparty. These are both examples of counterparty exposure limits.