Perhaps you have heard of the term but don’t quite understand what it is. If you are borrowing, investing, saving, or owning, running, and operating a business, this is a crucial component to understand. Understanding it allows you to plan better and structure your money to protect yourself.
To help explain things, I will use examples and I will say “bank”, but that doesn’t only cover banks. It’s just the entity with which all of us are familiar with. Bank in these examples can mean a company or a person.
What is counterparty risk?
Say that you borrow money from a bank. The bank, will run some tests to reduce risk on their end. They will look at your credit score, your income, past history (often obtained from the credit report, in the United States), etc. They are looking to see how much risk lending you money will expose them to.
You are in this scenario a counter-party risk to them making income. Because if you default (stop paying them back), they lose their income and potentially the original amount of money they loaned you.
Another example of counter-party risk is for investors. Say that you purchase a bond from XYZ company. You do that, because you believe that they will not only pay you as agreed upon, but will also return your initial investment, at some point in the future.
But, what if the company, runs into financial trouble and cannot pay you back? You could potentially find yourself not get your money back or income you were counting on. You are exposed to the counter-party risk. A risk that the other party will not pay you back.
What does this mean to you?
Just like you can be a risk to the bank, the bank can be a risk to you.
How so?
Say that you put money into a savings account with a bank. If that bank is not properly funded, they could find themselves over their head, having to pay more than what they make. That bank may need to file for bankruptcy and with that you may not get all or any of your money back.
Another example of counter-party risk is your job.
Wait, WHAT?
Yes, your job.
If you have a job with a company that is overextended, they may decide to cut down expenses and often part of that equation is, well to be blunt, you!
Payroll expenses are rather large for many businesses, so the quickest way to get out of the sticky situation is to lay people off.
If they are extremely overextended, they may file for bankruptcy as well and close the doors.
Whichever methodology they use, the end result for you is exactly the same: you are unemployed.
How do I reduce my counterparty risk?
If we go back to you being the borrower and the bank is not as satisfied with your financial background, they will likely ask for a co-signer and that person will have to have a satisfactory financial history. Whether there are questionable items in your credit history or you simply don’t have as long of a history as they would like, they will likely ask for a co-signer. Consider this bank’s insurance policy.
One of the ways that banks and the government want you to feel more comfortable with placing your hard-earned cash in with them is by offering FDIC. FDIC stands for Federal Deposit Insurance Corporation. You will see that majority of banks here in the U.S. have statements about your money being covered by the FDIC up to $250,000.
One of the ways that you reduce the counter-party risk with a bank is by placing up to that amount in the bank.
Another way is to do your due diligence. Investigate and run the historical and current performance of the bank, business, or person you’re planning to enter into an agreement with. Just like they check you out, you should be checking them out.
Finally, you can reduce your counter-party risk by diversifying where you keep your money and your investments.
This can mean:
- Banking at a few different institutions. This is not the best strategy, as all of the financial institutions today are extremely interconnected and co-dependent.
- Having your money inside and outside the banks.
- Holding multiple assets and sources of income.
- Purchasing “insurance” by owning items that have no counter-party risk.
To reduce your risk, when it comes to your employment, make sure you
- Investigate the company and their financials (not always easy, but really important).
- Create multiple streams of income. You can do this by owning businesses, holding side gigs and multiple jobs, or investments. This way, if one dries up, you still have money coming in.
- Have money in a contingency account to get you through the rough patch.
So, how exposed are you? Find out what asset does not have any counterparty risk?
