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What Is 'Counterparty Risk'?

Counterparty Risk is the possibility that other people won't deliver what they have promised.

The more your system depends on other people, the higher the risk of failing.

If your system relies on the performance of other people, you need to prepare for the possibility that they won't reach your expectations.

Josh Kaufman Explains 'Counterparty Risk'

If your system relies on other people in order to function, that poses a major risk to the operation of your system.

Counterparty Risk is the possibility that other people won't deliver what they have promised.

If your house burns down, you can only make a claim on your homeowner's insurance if the company you purchased the insurance policy from is still in business. If it's not, you're in trouble.

If your manufacturing system relies on a third-party vendor to supply certain parts, and they're not able to honor their commitments, your manufacturing line stops.

If you outsource work to a contractor, and that contractor doesn't perform as promised, your project will be delayed.

Too much Counterparty Risk increases the risk of catastrophic system failure. In the 2008 Wall Street crash, the world's largest investment banks stood on the brink of failure because they all relied on each other in the event something went wrong.

Investment banks and financial firms like Goldman Sachs, JP Morgan, and Lehman Brothers made a practice of buying "credit default swaps," a form of financial Insurance, from other large firms.

If a highly Leveraged deal went south, these investment banks thought the insurance they purchased would protect them from multi-million dollar losses, so they took on more and more leverage, increasing their risk exposure.

When the housing market collapsed and the banks started losing money on the mortgage securities they held, they tried calling in their credit default swaps. Lo and behold, the other banks they purchased the swaps from had also lost a huge amount of money on mortgage-backed securities, and couldn't honor the obligation.

Every large investment bank was a counterparty to the risk of the other banks in the system. Because they all relied on each other, when one bank fell, they all fell.

Counterparty Risk is Amplified by the Planning Fallacy. Your partners can't predict the future any more than you can, and everyone has a tendency to be optimistic regarding plans and deadlines.

Make plans and commitments, but always have a plan for when the project doesn't go as expected. When your system relies on the performance of someone outside of your control, do all that you can to prepare for the possibility that they won't perform as expected.

Questions About 'Counterparty Risk'

• Are other parties responsible for supplying inflows or processes in your system?
• What is the risk that they won't perform as expected, and how would a failure effect your system?
• Can you minimize or mitigate that risk?

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"The man who makes everything that leads to happiness depend upon himself, and not upon other men, has adopted the very best plan for living happily."

Plato, ancient Greek philosopher

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