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Counterparties are crucial in transactions but they also pose risks

What is a counterparty?

A trade will never be complete without a counterparty. But who is this person? The counterparty is the person on the other side of the trade, thus the name. Let us say that there is a buyer. But will there be a trade if there is no seller? The same is true if we turn the situation around. Will there be a trade if there is no buyer?

The term counterparty may involve individuals, companies, businesses, governments, organizations, and the like. Let us say that on one hand, we have a company giant, and on the other, we have a private individual. Does it matter? These participants do not need to have equal standing. The only important thing is that the counterparty meets the general contract requirements or the two parties develop an exchange agreement. These two parties consider each other as the counterparty. This is not limited to equities. It is also applicable to forwards contracts or others.

Counterparty risks

We say that a counterparty is essential in the transaction equation to happen. However, the counterparty himself already poses some risks. What is it? The counterparty may not be able to complete everything needed to do until the end of the transaction. While this is true and possible, there are many ways to avoid this, and clearing firms help in this department. Let us say that you are a buyer. You will not even personally know the counterparty or the seller on the other side of the trade. Also, there will most likely be several counterparties making each piece of the trade.

Let us classify them.

Who are the counterparties of different entities? If you can have an idea who your counterparty can be, would you want to know? You should because having an idea who the counterparty might be may help you get an idea about the market. You can apply this idea to your orders and transactions according to your trading style. Let us enumerate some of the counterparties:

  • Retail. They are the regular individual investors and nonprofessional traders who trade via online brokers.
  • Market makers. They give liquidity to the market while trying to generate profit from the market.
  • Liquidity traders. They generate profit by making liquidity and attracting the ECN credits. Although, they are not market makers, and they have cheap fees.
  • Technical traders. They trade while maximizing charts from market indicators and patterns involving support, resistance, trend lines, and graphs.
  • Momentum traders. There are several types of momentum traders. Some remain on a momentum stock for a few days, while others prefer those on the move.
  • Arbitragers. They use multiple assets, markets, tools, and the like to take advantage of market inefficiency across different markets. Some are small, and some are large since some arbitrage trading may require massive buying power to exploit market inefficiencies.

Finally, counterparties in a financial transaction

If you walk into a store, the counterparties would be the buyer and the seller. It’s quite the same in financial markets because the counterparties are the bond seller and buyer. Several counterparties may happen simultaneously. Counterparties show us that there are always two sides to every transaction.

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