What is a Counterparty?
A counterparty is the other party that participates in a financial transaction, and every transaction must have a counterparty in order for the transaction to go through. More specifically, every buyer of an asset must be paired up with a seller who is willing to sell and vice versa. For example, the counterparty to an option buyer would be an option writer. For any complete trade, several counterparties may be involved (for instance a buy of 1,000 shares is filled by ten sellers of 100 shares each).
The term counterparty can refer to any entity on the other side of a financial transaction. This can include deals between individuals, businesses, governments, or any other organization. Additionally, both parties do not have to be on equal standing in regards to the type of entities involved. This means an individual can be a counterparty to a business and vice versa. In any instances where a general contract is met or an exchange agreement takes place, one party would be considered the counterparty, or the parties are counterparties to each other. This also applies to forward contracts and other contract types.
A counterparty introduces counterparty risk into the equation. This is the risk that the counterparty will be unable to fulfill their end of the transaction. However, in many financial transactions, the counterparty is unknown and the counterparty risk is mitigated through the use of clearing firms. In fact, with typical exchange trading, we do not ever know who our counterparty is on any trade, and often times there will be several counterparties each making up a piece of the trade.
- A counterparty is simply the other side of a trade - a buyer is the counterparty to a seller.
- A counterparty can include deals between individuals, businesses, governments, or any other organization.
- Counterparty risk is the risk that the other side of the trade will be unable to fulfill their end of the transaction. However, in many financial transactions, the counterparty is unknown and the counterparty risk is mitigated through the use of clearing firms.
Types of Counterparties
Counterparties on a trade can be classified in several ways. Having an idea of your potential counterparty in a given environment can provide insights into how the market is likely to act based on your presence/orders/transactions and other similar style traders. Here are just a few prime examples:
- Retail: these are ordinary individual investors or other non-professional traders. They may be trading through an online broker like E-Trade or a voice broker like Charles Schwab. Often, retail traders are seen as desirable counterparties since they are assumed to be less informed, have less sophisticated trading tools, and are willing to buy at the offer and sell at the bid.
- Market Makers (MM): These participants' main function is to provide liquidity to the market, yet they also attempt to the profit from the market. They have massive market clout, and will often be a substantial portion of the visible bids and offers displayed on the books. Profits are made by providing liquidity and collecting ECNrebates, as well moving the market for capital gains when circumstances dictate a profit may be capturable.
- Liquidity Traders: These are non-market makers who generally have very low fees and capture daily profits by adding liquidity and capturing the ECN credits. As with market makers they may also make capital gains by being filled on the bid (offer) and then posting orders on the offer (bid) at the inside price or outside the current market price. These traders may still have market clout, but less so than market makers.
- Technical Traders: In almost any market, there will be traders who trade based on chart levels, whether from market indicators, support and resistance, trendlines or chart patterns. These traders watch for certain conditions to arise before stepping into a position; in this way, it is likely they can more accurately define the risks and rewards of a particular trade. At commonly known technical levels, the liquidity traders and DMM may become technical traders. Although not always in the way expected - DMM may falsely trigger technical levels knowing large groups of traders will be affected, thus churning large amounts of shares. (Learn more in our Technical Analysis Strategies for Beginners.)
- Momentum Traders: There are different types of momentum traders. Some will stay with a momentum stock for multiple days (even though they only trade it intraday) while others will screen for "stocks on the move," constantly attempting to capture quick sharp movements in stocks during news events, volume or price spikes. These traders typically exit when the movement is showing signs of slowing. (This type of strategy demands controlled decision making, requiring a continual refinement of entry and exit techniques, read Momentum Trading with Discipline.)
- Arbitragers: Using multiple assets, markets and statistical tools, these traders attempt to exploit inefficiencies in the market or across markets. These traders may be small or large, although certain types of arbitrage trading will require large amounts of buying power to fully capitalize on inefficiencies. Other types of "arbitrage" may be accessible to smaller traders such as when dealing with highly correlated instruments and short-term deviations from the correlation threshold.
Counterparties in Financial Transactions
In the case of a purchase of goods from a retail store, the buyer and retailer are counterparties in the transaction. In terms of financial markets, the bond seller and bond buyer are counterparties.
In certain situations, multiple counterparties may exist as a transaction progresses. Each exchange of funds, goods or services in order to complete a transaction can be considered as a series of counterparties. For example, if a buyer purchases a retail product online to be shipped to their home, the buyer and retailer are counterparties, as are the buyer and the delivery service.
In a general sense, any time one party supplies funds, or items of value, in exchange for something from a second party, counterparties exist. Counterparties reflect the dual-sided nature of transactions.
In dealings with a counterparty, there is an innate risk that one of the people or entities involved will not fulfill their obligation. This is especially true for over-the-counter (OTC) transactions. Examples of this include the risk that a vendor will not provide a good or service after the payment is processed, or that a buyer will not pay an obligation if the goods are provided first. It can also include the risk that one party will back out of the deal prior to the transaction occurring but after an initial agreement is reached.
For structured markets, such as the stock or futures markets, financial counterparty risk is mitigated by the clearing houses and exchanges. When you buy a stock, you don't need to worry about the financial viability of the person on the other side of the transaction. The clearing house or exchange steps up as the counterparty, guaranteeing the stocks you bought or the funds you expect from a sale.
Counterparty risk gained greater visibility in the wake of the 2008 global financial crisis. AIG famously leveraged its AAA credit rating to sell (write) credit default swaps (CDS) to counterparties who wanted default protection (in many cases, on CDO tranches). When AIG could not post additional collateral and was required to provide funds to counterparties in the face of deteriorating reference obligations, the U.S. government bailed them out.
For more on this topic risk, see our Introduction to Conunterparty Risk.