Hi there. In this post, I would like to cover what is counterparty risk. This concept is covered in financial news on TV, on alternative finance Youtube channels and such. It sounds like complicated jargon but I think it is not that hard of a concept.
Note Some of the contents in this post is opinion. Do manage your funds at your own risk.
Some Promises Are Not Kept
Before getting into the definition of counterparty risk, I want to start with a simple example. Suppose you do tutoring services in your specialty subject. Your service and expertise is exchanged for money in the form of cash, a digital payment or maybe even cryptocurrency. A natural skeptical question would be What if I do not get paid after tutoring.? The likelihood or probability of not receiving money can be related to counterparty risk.
Defining Counterparty Risk
When I think of counterparty risk, I think of the likelihood or probability that a monetary transaction ends up not being fulfilled. A transaction can be not fulfilled if a borrower does not pay back the money that is owed or if a person/company defaults.
The Investopedia definition is as follows:
Counterparty risk is the likelihood or probability that one of those involved in a transaction might default on its contractual obligation. Counterparty risk can exist in credit, investment, and trading transactions.
Counterparty risk is also known as default risk. This is the risk or chance that a company or individual would be unable to pay off debts.
Credit Ratings As A Measure Of Counterparty Credit Risk
Lenders do make money on interest when they loan out money to borrowers. The interest is a penalty for borrowers who do not pay debts on time. Borrowers have to worry about paying their debts on time so they don't pay crazy interest fees and let compound interest get out of control. On the other hand, lenders have to worry about borrowers who would not be able to pay their debts. Borrowers could run out of money, face criminal charges or pass away.
A credit score is a measure that rates the trustworthiness of a borrower. Credit score measures are estimated with the use of past historical records of loan payments, statistics and some elements of AI and machine learning. Higher credit scores indicate that the individual/company is financially trustworthy and pays their debts off and on time. Those with higher credit scores can end up being able to access more loans and of higher amounts. Low scoring individuals would not qualify for many loans as they are not reliable in paying off loans. Those with low credit scores are seen as those who are risky to lenders.
Counterparty Risk With Gold & Silver Delivery
To keep up with what is going on in the world, I do listen to financial news on the side. Currently, I do not follow the mainstream financial news as they do not really cover gold, silver, crypto.
The idea of paper contracts of gold and silver that have a future delivery date does sound suspect to me. I would prefer to have the asset now and in my hands. A future delivery date for any asset/commodity specified in a contract for any asset is a counterparty risk. It is not guaranteed that delivery will happen at the delivery date.
Wouldn't Counterparty Risk Be Eliminated If There Is No Credit Based System?
I would say no. There would still be financial contracts that would involve non-credit payments and delivery at a future date. Humans are not perfect and there are shady people out there who don't follow through on their promises. A good thing about a no credit based system would be less leverage leading into smaller losses in theory.
