Counterparty Risk In Everyday Products

Counterparty risk is the possibility that the institution on the other side of an arrangement fails to perform. It appears in more everyday products than the term suggests.

Owning an asset differs from holding a claim

A portfolio of shares held in custody consists of assets belonging to the investor, with the custodian holding them on their behalf rather than owning them.

A structured product, by contrast, is typically a debt obligation of the issuing institution. The holder owns a promise rather than a portfolio.

The distinction becomes decisive if the institution fails, since assets held in custody and claims against the institution are treated very differently.

Deposits are claims on a bank

A deposit is money lent to the bank, which uses it in its business. The depositor holds a claim rather than a segregated pot of cash.

Deposit protection schemes exist to address this, covering balances up to a defined limit per person per institution.

Those limits, the institutions covered and how joint accounts are treated vary by jurisdiction and change over time, so the applicable scheme's own terms are what govern.

Derivatives create ongoing exposure

A fund using swaps or forwards depends on the counterparty performing over the life of the contract, which is why collateral arrangements exist.

Collateral is posted and adjusted as the value of the contract changes, limiting how much exposure accumulates between adjustments.

Central clearing moves this exposure to a clearing house for many contract types, which concentrates it in an institution designed and regulated for the purpose.

Securities lending introduces a second party

Funds that lend holdings receive collateral in return. If a borrower fails to return the securities, the collateral is used to replace them.

The exposure therefore depends on whether the collateral is sufficient and can be sold at the needed moment, which is a question about quality and liquidity.

Fund documentation states lending policies, collateral standards and how any income is shared, and these differ substantially between providers.

Protection covers failure, not losses

Compensation arrangements for investment firms generally address the firm failing and client assets being unavailable, rather than investments falling in value.

Confusing the two leads people to believe they are protected against outcomes no scheme covers, which is a misunderstanding with practical consequences.

Establishing what a holding actually is, and which institution stands behind it, answers most questions about which protections could apply at all.