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What is Counterparty Risk and Why Does It Matter?

In Short: Counterparty risk is the risk associated with the other party to a financial contract not meeting its obligations. It is the likelihood or probability that one of those involved in a transaction might default on its contractual obligation.

When you make any investment, you’re always assuming some sort of risk.

When you invest in stocks, for instance, your principal (original) investment can decrease or even go to zero if a company performs poorly enough. Alternative investments like real estate can lose value in the same way that they gain value, risking some or all of your principal. Even savings accounts, long thought to be the safest place to put your money, are not entirely without risk.

One risk that’s slightly easier to understand than others is counterparty risk, sometimes known as default risk. This is a type of risk one could potentially encounter in bond investments and debt investments, including those on Percent. Yet learning what this risk is and how to see it before it happens is something every investor must know.

What is Counterparty Risk?

Counterparty risk is the risk of another party involved in a debt deal not living up to their agreed-upon obligations. For instance, the borrower of a loan has the potential to not pay back the loan on time or at all. The liklihood of them paying back the loan varies, but the off chance that they don’t is the counterparty or default risk that the lender assumes in the first place. (The “default” in default risk comes from the potential for the borrower to default on their loan.)

There is always counterparty risk in debt deals, though it doesn’t necessarily mean the counterparty (or, in the case of debt deals, the borrower) will default. At the same time, it cannot be assumed that the counterparty will always be 100% faithful to their obligations to a loan or note.

How to Navigate Counterparty Risk

Seeing as counterparty risk exists in all deals of debt and credit, performing due diligence on the borrower, other transaction parties, and the deal itself is always a necessity. While you cannot predict the potential for a borrower to default with 100% accuracy, you can examine past borrowing and financial history, as well as other facts and figures that may or may not show the financially competency of the borrower.

If a borrower has past history of defaulting, there is a higher chance of them doing it again. At the same time, a borrower who never defaulted on a loan before is not immune to doing so.

There are a multitude of other reasons why a counterparty could fail to honor their commitments. They could lack the financial capacity to pay, sure, but they can also face disruptions in business, operational failures, regulatory/legal issues, or any number of shortcomings that could ultimately lead to a default. It’s worth performing gauging these and other risks while performing due diligence.

How This Risk Applies to Percent Deals

Percent investments all come with some form of counterparty risk. Fortunately, we provide as much insight about the history of the deal and all parties involved in each deal’s report, along with the progression of repayments throughout the duration of each deal. This allows you to kickstart your due diligence and research into all parties involved, mitigating any risk.

It’s worth noting that, as of February 2021, only 1.1% of deals on Percent have experienced some level of default in the process.

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