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Managing a complex trading portfolio comes with a lot of responsibility. Any errors or oversights on your end affect your client’s finances, so it’s important to understand the risks you’ll likely encounter and how to mitigate them. While factors like market uncertainty and volatility may be more obvious considerations, counterparty risk deserves attention, too.
What Is Counterparty Risk?
Counterparty risks refer to any risk of the other party in a financial transaction not upholding their end of the deal. The most straightforward example is a default risk, where the other party defaults on required payments. However, they can get more complicated than that, especially when dealing with derivatives.
The 2008 financial crisis highlights an extreme example of counterparty risk. Widespread reliance on subprime lending led to a domino effect of collapses as borrowers became unable to pay mortgages. In a more recent example, Archegos Capital collapsed after owing billions more than it had — largely the result of market manipulation that were making investments seem more valuable than they were.
How Counterparty Risk Affects Financial Advisors
Losing money from another party that is failing to perform as required by contract is undesirable in any context. The consequences are much more severe as a financial advisor because it’s not your money this risk affects.
Failing to properly account for counterparty risk can result in your clients losing considerable amounts of money. In extreme cases, your clients may claim these losses are the result of fiduciary negligence. That would make you personally liable for the compensation of these damages if the court agrees it’s a matter of negligence.
Outside of this extreme, losses from counterparty risks will likely erode trust in your services. That, in turn, will lead to lost business and a tarnished reputation.
How to Mitigate Counterparty Risk
As a financial advisor, you have a responsibility to recognize and respond to counterparty risk in potential investments for your clients’ portfolios. Here are a few ways to minimize this risk and reduce the damages when accepting it.
1. Be Thorough in Due Diligence
Due diligence is the first and most important step in addressing counterparty risk. While cases like the Archegos Capital collapse show it’s sometimes difficult to spot all risks, you can watch for some common warning signs. Parties with fewer assets, less collateral and more extreme market exposure or without a strong reputation generally have higher counterparty risks.
Sometimes, these risk factors are easier to spot than others. Artificial intelligence (AI) can help fill the gaps when market complexities and high workloads make it difficult to accurately quantify anything. AI can recognize early signs of market changes, mitigate human bias and consider more subtle factors to offer more reliable risk assessments.
2. Emphasize Transparency
As part of this due diligence, you should aim to raise standards for transparency all around. Counterparty risks go both ways, so you can’t expect other parties to be open about their finances and risk profiles if you aren’t also transparent.
Be upfront with your clients about potential risks and your approach to them. Similarly, offer as much information as necessary to the other side in an investment deal so they understand any risks associated with your clients. Starting this practice in your own business will help foster a broader shift towards transparency.
3. Diversify Risks
While it’s important to minimize risk wherever possible, some unpredictability is inevitable. Consequently, you must also employ measures to reduce the impact of the risks you accept. One of the most common risk management mistakes to avoid is failing to diversify your trades.
Diversifying your clients’ investments between markets and asset types minimizes the effects of any one area taking a turn for the worse. Don’t accept too much counterparty risk in one area. Rather, spread these vulnerabilities out between separate exchanges and kinds of contracts to make significant losses less likely.
4. Match Premiums According to Risk
Another strategy to minimize potential losses is to accept counterparty risk at a premium. As mentioned earlier, these risks go both ways, but sometimes the other party represents a riskier investment than you or your clients. When that happens, you can require additional charges or a clause covering reimbursement as an insurance policy against counterparty risk.
You can apply these to your clients, too, requiring a premium to offer your services to higher-risk investors or adding fees for high-risk investments. Remember to match these rates to the level of risk instead of using a flat fee. Once again, AI is a useful tool here, as it reduces false positives and improves accuracy in risk assessments.
5. Take Advantage of Credit Default Swaps
You can also hedge against counterparty risks through a credit default swap (CDS). As the name suggests, a CDS swaps one party’s credit risk with another’s, allowing a lender to offset the risk of a default. Consequently, the less risk-prone party reduces the impact of the other’s counterparty risk.
While a CDS can be a helpful strategic tool, approach them carefully. Like any bilateral agreement, these agreements carry their own counterparty risks. That risk made CDS play a central role in the 2008 financial crisis, leading to the downfall of Lehman Brothers and Bear Stearns. Regulations since then have made them safer, but you should still be cautious.
Financial Advisors Must Consider Counterparty Risks
Counterparty risks demand attention, especially when your clients have complex, high-value portfolios. Learning more about these hazards and how to mitigate them is key to protecting both your business and your clients. Recognizing these risks and applying these five strategies to address them will help you conduct business more safely in the future.
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