Counterparty Risk

What is counterparty risk?

Counterparty risk, also called default risk, refers to the likelihood that a participating party in a financial transition may fail to fulfill its contractual obligations. Counterparty risks include all parties involved in a transaction and exist in investments, market conditions, exposure, lines of credit, and trading transactions. 

Who is exposed to counterparty risk?

Any company or business involved in a financial transaction is exposed to counterparty risk. Since maritime shipping and trading is one of the largest global industries, shippers and carriers are predominantly exposed to counterparty risks. When evaluating a shipping contract, counterparty credit risk analysis should be thoroughly conducted by all participating businesses and financial institutions before agreeing on a joint shipment process.  

What is an example of a counterparty risk?

Every exchange of goods, services, or funds in a financial transaction is considered counterparty and therefore contains risk. For example, if a consumer purchases a product online, the consumer, retailer, and delivery service are counterparties. Loaning money to a friend makes the friend a counterparty or credit risk and is expected to pay back their loan. In maritime shipping and trading, the value of goods, the vessel operators, and the shipping routers are all examples of counterparty risks. 

How is counterparty risk scored?

Counterparty credit risk analysis tries to capture all the risk of loss of one party if the other defaults on their counterparty contract. In lending and borrowing, a credit score is given to a borrower based on their analysis and credit history. This numerical value identifies a business’s risk level. A high score means a company is more trustworthy to fulfill its contractual obligations and therefore has lower counterparty risk. A low score means a higher risk. 

Factors of counterparty risk 

Many variables go into determining a counterparty credit risk analysis of a business. Payment history, company debts, credit utilization (the amount of available credit currently in use), and the length of credit history of a company are key factors to know to assess counterparty risk.

In maritime shipping and trading, there are several factors to consider about the carrier when measuring counterparty risk.:  

  • Do they have a history of chartering ships? 
  • How did they perform on prior chartered shipping freights? 
  • Do they comply with international law and regulations, or have they been sanctioned? 
  • Do they enter unsafe ports or territory? 

What are freight derivatives?

In general, derivatives are financial instruments that derive their value from fluctuations underlying assets or the performance of assets. Derivatives include structured debt obligations and future options. For a bank, its loan portfolio is usually its greatest financial asset and, therefore, also its greatest source of risk assessment. For shippers, it’s the freight and fuel of the ship. 

Freight derivatives are often used by ship owners and suppliers, like international trading corporations, to mitigate risk. Freight derivatives are values from the future levels of freight rates, such as dry bulk delivery rates or oil tanker rates, and protect against price volatility in shipping rates. It is used by shippers and ship owners to manage freight rate risk. 

A forward freight agreement (FFA) is the contract used that allows ship owners and charters to hedge against volatile freight rates and allows contractors and ship owners the right to buy and sell the price of freight for future dates. FFAs are also used to manage freight rate risk. 

Do outside investors affect counterparty risks?

Maritime markets for shipping across seas is one of the largest industries in the world and attract outside investors. However, the shipping industry depends on the supply and demand of commodities and goods, making the market volatile. Outside investors have changed the way risk is managed in maritime shipping and trading. Investors prefer stability and therefore influence long shipping partnerships. For investors, dry bulk and tanker sectors are seen as high-risk as they are chartered for shorter periods. 

What are some counterparty risk assessments?

In shipping and trading, there are a few areas that need to be specifically assessed in counterparty risk management. They are: 

  • Fuel – is a large risk for ship owners. The fuel market has its own financial tools or derivatives to enable buyers to manage their fuel price risk. 
  • Dry bulk pricing – are dry bulk goods shipped in large parcels to manufacturers and producers, such as coal, grain, and metals. Dry bulk indexes are used to measure the prices of dry bulk. 
  • Corruption and compliance – bad shipping practices and illegal activities can occur, and therefore, an increase in regulations and sanction risk exposures are used to protect companies in a contract. 
  • Piracy – is one of the largest risks shipping has dealt with over the last decade. As fuel and cargo prices go up, so does the risk of international piracy for ransom.

Counterparty risk management best practices:

There are standardized practices that are taken by counterparty risk solution experts to enable smooth financial transactions between two parties:

  • Standardized contracts
  • Use of central clearinghouse 
  • Requiring delivery versus payment (DVP) 
  • Use of third-party repurchase agreements 
  • Match commodities or goods with counterparty risk assessments

What happens if a shipping contractor is assessed as risky? 

If one party is assessed as having a higher risk of default, then a premium is attached to the contract. Called a risk premium, the investment return of an asset is expected to yield in excess and is used to compensate the other contractual party. It represents payment for tolerating a defined extra risk in the given contract over that of a risk-free asset or a certain future return. 

What is a counterparty risk solution? 

Counterparty risk solutions help shippers and carrier contractors understand their counterparty risk exposure and allow them to price risks into trades and monitor their exposure to the market in real-time. Counterparty risk solutions comply with regulations and auditing. Windward uses AI to provide comprehensive risk management solutions for maritime domain awareness and all maritime shipping and trading entities and third parties. Windward solves the toughest risk assessment challenges by leveraging machine learning technology and maritime domain expertise to predict and offer insights for shippers to choose the best counterparty risk practices.