Counterparty risk
What happens when the other side of a trade cannot deliver what it promised?
In plain words
Counterparty risk is the chance that the person, desk or institution on the other side of a trade fails to pay or deliver at settlement. It exists whenever an obligation is owed by someone else rather than settled immediately.
Why it matters
A position can be correctly priced and still lose money if the other side defaults, so exposure is not only to price direction but also to who owes what. Rapidly falling markets are when this risk concentrates, because losses and margin calls arrive together across many accounts.
In a real week: BTC, week of 24 February 2020
In the week of 24 February 2020, BTC fell 14.14%, from 9936.4 to 8531.88, with an 18.77% range and realised volatility of 56.6% annualised; volume ran 1.31 times its prior 12-week average and the week closed in the lower third of its range. Moves of this size and speed pressure every party that owes collateral or delivery, since obligations fall due within days while account values decline.
A common mistake
Treating counterparty risk as a problem only for small or unfamiliar counterparties. A large, established institution can default too, and a profitable trade still loses if the other side cannot pay.