What is Counterparty Risk?
Counterparty risk refers to the potential financial loss or operational disruption that can occur in the maritime industry when one party involved in a transaction or contract fails to fulfill its obligations. Meaning, there’s a chance the other party might not keep their promises, or pay what they owe.
What is Regulatory Risk?
Regulatory risk refers to the potential impact of changes in regulations or government policies and the risk that your counterparty could be sanctioned, or is working with sanctioned entities, and could therefore expose you to risk. Know your customer (KYC) references a set of guidelines that financial institutions and businesses follow to verify the identity, suitability, and risks of a current or potential customer. The goal is to identify suspicious behavior, such as IUU fishing and sanctioned commodity smuggling, before it exposes one’s business to risk.
It is important to stay on top of emerging risks with complete sanctions-compliance evaluations and illicit activities detection, and remain in-line with market events and trends.
What is Financial Risk?
Financial risk relates to the potential for financial loss due to the inability or failure of a counterparty to meet its financial obligations.
Who is Exposed to Counterparty Risk?
In the dynamic maritime industry, knowing who you are doing business with is critical. Several entities face exposure to counterparty risk due to the complex network of transactions, contracts, and operations involved:
- Ship owners and operators: companies that own or operate vessels are exposed to counterparty risk when entering into charter agreements. If charterers fail to make payments or don’t fulfill their obligations, it can lead to financial losses for the ship owners or operators. It’s crucial that ship owners and operators know who they are doing business with so that they are not exposed to sanctioned entities or illicit actors.
- Charterers and cargo owners: entities chartering vessels for transporting goods or commodities are exposed to counterparty risk. If they fail to make payments or provide cargo as agreed, it can impact the shipowners’ revenues or disrupt operations. If charterers are using risky vessels or dealing with sanctioned entities, this could lead to regulatory exposure.
- Financial institutions: banks and financial entities providing financing, loans, or trade finance services to maritime businesses are exposed to counterparty risk. If the borrowing maritime companies default on their obligations, it can lead to financial losses for the lenders. Suspicious behavior, such as money laundering, can lead to regulatory exposure.
- Insurance and reinsurance companies: insurers providing marine insurance coverage face counterparty risk if the insured parties’ counterparties fail to meet their financial, operational, and regulatory obligations, leading to insurance claims.
What is an Example of Counterparty Risk?
One example of counterparty risk in the maritime sector could involve a scenario where a shipping company enters into a charter agreement with a charterer to transport goods. The shipping company, as the vessel owner or operator, faces the risk associated with the counterparty, the charterer.
Let’s say a shipping company agrees to lease out one of its vessels to a charterer for transporting a specific cargo from Country A to Country B. The charter agreement includes terms for the duration of the charter, the freight rates, and other operational details.
But the charterer may fail to fulfill its obligations in several ways:
- Non-payment: the charterer may fail to make timely payments for the agreed-upon charter fees, or might default on payments entirely, causing financial strain on the shipping company that relies on these payments for its revenue stream.
- Cargo default: the charterer might not provide the cargo as agreed, leading to an empty voyage for the vessel. This results in lost revenue for the shipping company and potential additional costs associated with the unproductive voyage.
- Operational disruption: if the charterer defaults or fails to perform its obligations, it can disrupt the shipping company’s operations, leading to inefficiencies, or the need to find alternative charter agreements on short notice, which could be more expensive or less profitable.
- Deceptive shipping practices: if the vessel that is chartered is involved in deceptive shipping practices during the time of the trade agreement, this can expose shipping stakeholders to regulatory and financial risks.
Shipping companies face counterparty risk from charterers, as their failure to fulfill contractual or regulatory obligations can lead to financial losses, operational disruptions, and potential contractual disputes. To mitigate this risk, shipping companies should conduct thorough due diligence on the charterer’s financial stability, ownership and historical behavioral patterns; use contractual safeguards; and/or seek insurance coverage against potential losses arising from counterparty failures.
Factors of Counterparty Risk
Counterparty risk hinges on various factors. Historical behavior stands as a pivotal element, reflecting a company’s track record in fulfilling obligations, honoring agreements, adherence to regulations, and legitimate behavior by its fleet.
Ownership plays a significant role, delineating the financial stability and integrity of the party involved. Additionally, assessing the status of other vessels in the fleet contributes significantly, as it provides insights into the overall operational health and potential risks associated with the counterparties involved in maritime transactions. These factors collectively form the backbone of evaluating and mitigating counterparty risk in the dynamic seas of commercial maritime operations.
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 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: dry bulk goods are 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.
- Sanctions compliance: deceptive shipping practices and illegal activities can occur, so an increase in regulations and sanction risk exposures are used to protect companies in a contract.
What Happens if a Shipping Contractor is Assessed as Risky?
If one party is assessed as high risk due to potential regulatory reasons, this could be because of its connection to a sanctioned entity, deceptive shipping practices, or a relationship with sanctioned countries, for example, Russia.
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’s Maritime AI™ platform provides complete counterparty due diligence for any person or company across the supply chain, including all seven levels of ownership, and up to the ultimate beneficial owner (UBO), to discover hidden connections, future-proof audit reports, and customize sanctions and watch lists to monitor any compliance risk change.
We offer patent-pending deceptive shipping practices models for dark activities, location (GNSS) manipulation, and ship-to-ship operations.
Windward uses AI to provide comprehensive counterparty risk management solutions for maritime domain awareness and all maritime shipping and trading entities and third parties. It solves the toughest risk assessment challenges by leveraging machine learning technology and maritime domain expertise to predict and offer insights for organizations to choose the best counterparty risk practices.