Counterparty Definition

What is a consideration?

A counterparty is the other party that participates in a financial transaction transaction. Every transaction must have a counterparty for the transaction to be completed. Specifically, every buyer of an asset must be matched with a seller who is willing to sell and vice versa. For example, the counterparty to a option buyer would be an option writer. For any complete transaction, multiple counterparties may be involved (for example, a purchase of 1,000 shares is filled by 10 sellers of 100 shares each).

Understanding counterparties

The term counterparty can refer to any entity on the other side of a financial transaction. This may include agreements between individuals, companies, governments or any other organization.

Moreover, the two parties do not necessarily have to be on an equal footing. This means that an individual can be a counterparty to a company and vice versa. In all cases where a general contract is fulfilled 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 futures contracts and other types of contracts.

A consideration introduces counterparty risk in the equation. This is the risk that the counterparty will not be able to fulfill its part of the transaction.

However, in many financial transactions, the counterparty is unknown and counterparty risk is mitigated by the use of clearing companies. In fact, with typical exchange trading, we never know who our counterparty is on any transaction, and often there will be multiple counterparties, each constituting a part of the transaction.

Examples of consideration

In the case of a purchase of goods from a retail store, the buyer and the retailer are counterparties to the transaction. With regard to financial markets, the obligation seller and buyer of bonds are counterparties.

In some situations, multiple counterparties may exist during a transaction. Each exchange of funds, goods or services to complete a transaction can be thought of as a series of quid pro quos. For example, if a buyer buys a retail product online to have it delivered to their doorstep, the buyer and the retailer are counterparties, as are the buyer and the delivery service.

Generally speaking, whenever a party provides funds or valuables in exchange for something from another party, quid pro quos exist. Counterparties reflect the dual nature of transactions.

Types of counterparties

The counterparties to a transaction can be classified in several ways. Getting an idea of ​​your potential counterparty in a given environment can provide insight into how the market is likely to act based on your presence/orders/trades and other similar style traders. Here are some prime examples:

• Retail traders: These are ordinary individual investors or other non-professional traders. They can trade through an online broker like E-Trade or a voice broker like Charles Schwab. Often, retail traders are considered desirable counterparties because they are assumed to be less knowledgeable, have less sophisticated trading tools, and be willing to buy on the bid and sell on the bid. offer.
• Market makers: The main function of these participants is to provide liquidity in the market, but they also try to take advantage of the market. They have a massive influence in the market and will often make up a substantial portion of the visible offers and offers displayed in the books. Profits are made by providing cash and collecting REC discounts as well as move the market for capital gains when circumstances dictate a profit may be captureable.
• Liquidity traders: They are non-market makers that typically have very low fees and capture daily profits by adding liquidity and capturing ECN credits. Similar to market makers, they can also realize capital gains by being filled on the bid (bid) and then posting orders on the bid (bid) at the price inside or outside the current market price. These traders can still have influence in the market, but less than market makers.
• Technical traders: In almost every market there will be traders who trade based on chart levels, whether from market indicators, support and resistance, trend lines or chart patterns. These traders monitor certain conditions before taking a position; in this way, they are likely to be able to more accurately define the risks and rewards of a particular trade. At commonly known technical levels, traders in liquidity and designated market makers can become technical traders, but not always in the expected way – designated market makers can falsely trigger technical levels knowing that large groups of traders will be affected, thus producing large amounts of action.
• Dynamic traders: There are different types of momentum traders. Some will stick with a momentum stock for several days (even if they only trade it intraday), while others will look for “moving stocks”, constantly trying to capture sudden and rapid movements in stocks during current events, volume, or price spikes. These traders usually exit when the move shows signs of slowing down – this type of strategy requires controlled decision making, requiring continuous refinement of entry and exit techniques.
• Arbitrators: Using multiple assets, markets, and statistical tools, these traders attempt to exploit inefficiencies in the market or across markets. These traders can be small or large, although some types of arbitrage trading will require large amounts of buying power to take full advantage of inefficiencies. Other types of “arbitrage” may be available to small traders, such as when dealing with highly correlated instruments and short-term deviations from the correlation threshold.

Counterparty risk

In relations with a counterparty, there is an innate risk that one of the persons or entities concerned will not fulfill their obligation. This is particularly true for over the counter (over-the-counter). Examples of this include the risk that a seller will not deliver a good or service after payment has been processed, or that a buyer will not pay an obligation if the goods are delivered first. It can also include the risk that a party withdraws from the agreement before the transaction takes place, but after an initial agreement has been reached.

For structured markets, such as the stock exchange or futures contracts markets, the financial counterparty risk is mitigated by the clearinghouses Exchanges. When you buy a stock, you don’t have to worry about the financial viability of the person on the other side of the deal. The clearing house or stock exchange acts as a counterparty, guaranteeing the shares you bought or the funds you expect from a sale.

Counterparty risk has gained visibility in the wake of the 2008 crisis the global financial crisis. AIG leveraged its AAA credit rating sell (write) credit default swaps (CDS) to counterparties who wanted protection in the event of default (in many cases, secured debt instrument (CDO slices). When AIG was unable to provide additional collateral and had to provide funds to counterparties in the face of deterioration benchmark bondsthe US government bailed him out.

The essential

When we trade stocks or other financial instruments, we rarely think about the person/company on the other side of the transaction. Clearinghouses operate as an intermediary in financial markets, supervising transactions and ensuring that both buyer and seller honor their contractual obligations.

That doesn’t mean we shouldn’t be curious, though. As discussed in this article, knowing who your counterparty is can actually be quite enlightening.