A counterparty refers to the other party that completes the number of persons needed for a successful transaction. In layman terms, a counterparty is either a buyer or a seller, without which a transaction cannot take place. For a buyer who wants to purchase some items, the counterparty will be a seller who is willing to supply the buyer with his needs. Also, for a seller who is looking to sell off his inventory, the counterparty will be the buyer purchasing it. For a trade to be completed, the number of counterparties should be more than one. Thus, for 20 units of soap to be bought, there must be more than one or two buyers, depending on the unit being purchased by a single buyer.
A Little More on What is a Counterparty
Counterparty generally refers to the entity on the other part of a trade. For buyer, the counterparty will be a seller, and vice versa. Counterparties in financial transactions can include personal entities, businesses, governments and other international institutions. Also, there’s no required for equality on the part of both parties. In other words, a government agency can be the counterparty of a single seller of raw materials, a business might be the counterparty of an international organization that needs a certain product, or an exporter can be the counterparty of an importer. They actually don’t need to be on consecutive or same levels.
In a transaction, there’s what is called a counterparty risk. This is defined as the risk or possibility that the counterparty won’t be able to fulfill their end of the bargain. For instance, there’s a possibility that a buyer may take down a deal after the process has started due to one or two reasons, or there’s also a chance that he cannot afford the transaction cost. Also, a seller might leave a deal unfilled if he finds another buyer offering better benefits. To better mitigate this risks, transactions between counterparties are usually fulfilled by clearing firms, especially in cases where the parties involved are anonymous to each other. While it might sound surprising, almost everyone makes use of clearing firms. An instance is the trading environment. There’s no way t know who you’re bidding against, so the broker acts as the clearing firm in this case. Another examine would be a loan from a bank. The lender (the person with the account) has no idea who his money is given to, and the borrower doesn’t have an idea either about whose account the money was taken from.
- Counterparty refers to the other side of a financial transaction
- The level of the parties involved doesn’t matter, anybody can be the counterparty of another
- Counterparty risk refers to the risk that the other party won’t complete his part of the transaction. Clearing firms however help to prevent this risk as much as possible by acting as intermediaries between anonymous parties.
The Different Types of Counterparty
Counterparties in a market trade can be categorized in different ways. Having reliable information or insight into who your potential counterparty will likely impact how well you’re prepared to move the market in your favor. Here are some types of counterparties you’ll meet in a market
- Retail: Retail traders are usually non-professional and individual investors who engage in trading via retail brokers like Interactive Brokers or Charles Schwab. In most cases, these traders are attractive to other investors since they have a much more limited knowledge of how things really work in the market, have access to less sophisticated trading indicators and tools, and they’re always ready to buy at the offer and sell at the bid.
- Market Makers (MM): Market makers are usually the big game in the pool. They’re more interested in keeping the market alive, although they tend to lock in profits from time to time. These traders have sophisticated tools and they’re usually one of the leading factors in the direction of the market and what is offered on book. Market Makers usually get profits from ECN rebates and by providing liquidity. These traders also move the market for their own gains especially when there is a tendency of a capturable profit.
- Liquidity Traders: Liquidity traders are non market makers with low fees and they capture profits by adding liquidity to the market and collecting ECN credits. These traders are fairly respected in the market, but not as much as the market makers. They also tend to make capital gains by getting filled on the bid (offer) and then selling the offer at insiders price or at the existing market price.
- Technical Traders: Technical traders are the largest collection of traders as they draw a large audience from all sorts of market traders. These traders make use of charts levels, sometimes from indicators, trend patterns, or chart patterns. They’re usually watchful and they’re patient enough to wait for a perfect point of entry and exit in the market. Subsequently, one could say that they’re the largest groups that determines market risks. In some conditions, liquidity traders and Market Makers can become technical traders, although not in the same way as retail traders. A market maker can make a false move in the market knowing fully well that a large amount of technical traders will fall victim to this deceit, thus churning large amounts of shares.
- Momentum Traders: Momentum traders (usually called scalpers) are the fastest and most complex category of traders. They’re intraday traders who can study charts for several days (with the intention of trading it for just one day). Dominantly, they’re always on a lookout for quick movements that’ll allow them jump in on take sharp profits within seconds or minutes. These traders make use of technical indicators as well as news events, volume spikes and price patterns. Some momentum traders are capable of placing up to hundreds of trades per day, and they’ll only looking for small movements in their desired direction to exit the trade. Momentum traders are mostly disciplined, have perfect knowledge of risk and money management, and have perfect knowledge of entry and exit strategies.
- Arbitragers: Arbitrage means to look for exploit in the market and use it to one’s advantage. This traders usually take the less risky route of trading by making use of multiple assets and trading statistical tools. They’re always on the lookout for inefficiencies in markets of all sort. Arbitrage traders are usually wealthy individuals or entities with enormous buying powers, as they require a large buying power to benefit considerably from the little inefficiencies which they’ve identified. For instance, and arbitrage trader may get to spot a chance to make $.10 per share in a market. Buying 1000 units of such stock with $100,000 will only yield him a profit of approximately $100. Nobody wants to invest $100,000 to make just $100, and so, they’ll tend to use a higher buying power to get profits. They could choose to purchase 100,000 units of such a stock to make a profit of $10,000 or even purchase up to 10 million units of such a stock and make a million dollars. The later is quite rare though, as they’ll always careful not to expose the exploit before cashing out as much as possible.
Financial Transactions Counterparties
Outside the financial trading market, purchases from retail shops have a buyer and a seller who are acting as counterparties to each other. In a bonds market, the issuer and buyer are the counterparties.
In most cases, there can be multiple counterparties in a single transaction. An example would be an importer and an exporter. When exchanging products across shores, the importer and the exporter are counterparties. Also, the delivery service used in getting such products across is also a counterparty to the importer. Counterparties generally exist whenever a transaction is taking place. That is to say, no matter the transaction. type, as long as exchange takes place, then there are counterparties present.
As we discussed earlier, there is a tendency that one party might fail to fulfill their part of the bargain. This is mostly occurrent in over-the-counter transactions (OTC). There’s a chance that a seller will not deliver goods after a payment has been made, and that a buyer won’t pay for products after delivery has been made. Also, there’s another chance that a buyer might end a deal before it is processed, but after an agreement has been made, and that a seller might breach the agreement by taking on a new buyer after the agreement has been made.
In the stock market or other financial assets market, counterparty risk is reduced by clearinghouses and exchanges. A clearing house or a broker is usually in charge of making sure that funds bought are delivered to you, and that you’ll get paid for stocks you sold.
In the 2008 financial crisis, counterparty risk generally increased and gained traction. AIG leveraged its AAA credit ratings to write credit default swaps (CDS) to counterparties who needed default protection, on CDO tranches. When this firm became unable to provide funds to its counterparties, it got bailed out by the United States government.