Before the demise of Lehmans, AIG and the collapse of thousands of other financial powerhouses – the words “Counterparty risk” was generally used as more of a conjectural concept. Today the phrase is used to describe both the cause and effect of our global financial status-quo. Counter-party risk reduces confidence in financial instruments. Savings accounts, government bonds and low risk equities are now seen as a matter of last resort owing to its higher risk and lower reward reputation. The literary meaning of a savings account defies the purpose in which it should be used. It’s difficult to save if the level of return is less than the rising costs of living. It’s impossible to save, if the institution responsible for holding your savings has ceased to exist. The phenomenon of counter party risk goes beyond possible and now exists in a wide and spreading sphere of probable.
People can lose money in financial instruments regardless of the vigour of their investment. Owning an undervalued mining stock with great earning potential and little (perceived) downside risk still attracts the prospect of a board of directors manipulating its value. Equally, its bank’s reluctance to lend money and/or inflated borrowing rates has contributed to the demise of many companies over the last few years. Whilst Gold ETF’s track the price of physical gold – if a large proportion of holders were to sell their holdings, there wouldn’t be enough physical gold to cover peoples’ investments. The most prevalent example of counterparty risk is buying a low yielding government bond in Greece 7 years ago, only to discover that investors were forced to write up to 50% off their investments.
In order to save money, you need to be earning more than inflation (3.6%) in addition to any currency devaluation. In order to have money you need to ensure you have minimised counterparty risk by taking ownership and possession of the investment you have bought. Precious metals are an obvious example of this with the population turning to gold in times of austerity. Often the causes and effects of counter-party risk are the same:
Causes & Effects of Counterparty Risk
- 3rd parties taking uncalculated risk’s
- Exposure to debt in weak markets (e.g. Greece)
- Cost of borrowing increased
- Overall confidence diminished – reduces amount of cash and/or investment in entity
- Legal wrangling and unfavourable settlements diminish profit (e.g Payment Protection Insurance)
- Foreign Exchange exposures prevalent in uncertain markets
- Exposure to rouge traders