Counterparty risk refers to the possibility that one party in a particular transaction, could potentially end up defaulting. When used in the context of FX, counterparty risk typically refers to the possibility that the brokerage or trading venue used by a trader could default or collapse, leading to significant losses for the trader. Counterparty risk is something that FX traders should be aware of and incorporate into their decision making process. Thankfully, for the majority of retail FX traders counter party risk is relatively low, with retail clients often receiving regulatory protection. However, counterparty risk exists, and this article will delve into more detail regarding how counterparty risk effects retail FX traders.
Counterparty Risk and Market Makers
Typically, traders worry most about counterparty risk when dealing with brokerages who operate using a market making model. This is due to the fact that on occasions a brokerages profit can be equal to the losses of their clients, and vice versa. If a number of traders took large positions which suddenly moved massively in their favour the brokerage could feasibly find themselves in a situation where they could not cover their losses, ultimately leading the brokerage to default on it’s commitments. The regulation of Forex in many established financial centres (the EU, Australia, New Zealand, Japan and the US) make this a very unlikely event. This due to brokers regulated in reputable jurisdictions face stringent capital requirements and must also segregate client funds, meaning even if the brokerage did collapse it is likely the trader would be able to recover at least some of his funds. The existence of Investor Comepnsation Schemes in the EU and elsewhere mean that retail clients are able to recover at least some of their funds should their EU regulated brokerage firm collapse financially.
Traders using unregulated market makers face significantly more counterparty risk, as there is no guarantee that the broker will have ensured that they have adequate capital to cover any losses and may not even properly segregate client funds. Additionally, may also be the case that the brokerage doesn’t engage in the standard risk management procedures which would normally light the blow, should the market move significantly against a market maker. Often when such market makers lose significant sums during periods of significant market volatility, you will find traders complaining of market manipulation or the simple removal of profits from client accounts. This one way which rogue operators can manage risk and recover losses, when they are operating without proper regulatory oversight or risk management controls. The counterparty risk faced when trading with market makers highlights the value of doing business with brokerages regulated in reputable jurisdictions.
Counterparty Risk and the No-Dealing Desk Model
Often the No-Dealing Desk model is commended in part due to the fact that it can lead to a decrease in counterparty risk for the average retail trader. This is due to the fact that the brokerage simply passes on orders, making money through commission or a mark-up on the spread. So regardless of whether a trader wins or loses the brokerage should remain profitable provided they charge enough in terms of spread mark-up or in commission to cover their operating costs. While this might reduce the amount of counterparty risk faced by a trader it doesn’t remove the risk entirely.
The vast majority of retail FX brokerages offer their clients significant amounts of leverage, under normal market conditions does not pose a huge risk for the brokerage. In the case of massive market volatility, the offering of significant leverage can lead to significant counterparty risks. For instance, a large swing in the value of a currency pairing could lead to client accounts entering negative territory this can potentially lead the brokerage with losses that it may not be able to recover. This is exactly what happened during early 2015, when massive volatility in the Swiss Franc saw a number of No-Dealing desk brokerages owing significant sums to their liquidity providers which ultimately led to names such as Alpari UK, and LiquidMarkets declaring themselves insolvent. Often such risks can be managed, for instance in late 2014 during the significant volatility in the Ruble and the thin liquidity offered by liquidity providers many traders temporarily withdrew the RUB pairings from their platforms, in order to avoid such issues. Despite this it near impossible for ECN/STP brokerages to fully protect themselves against very extreme ‘Black Swan’ events, meaning that counterparty risk is always ever present for retail FX traders.
Mitigating Counterparty Risk
Counterparty risk can however be mitigated by retail traders. Firstly, by only trading with brokerages who are regulated in jurisdictions where their exists a proper regulatory framework and properly enforced adequate capital requirements, there is less risk of a brokerage collapsing financially. Additionally, many regulators operate investment compensation funds which allow retail clients to a certain amount of funds should a brokerage become insolvent. Another option for traders is to operate with multiple brokerages which spreads the risk around, meaning the default of one brokerage would not lead to a total loss of a traders fund. Though a more general industry collapse could hurt a trader significantly. While counterparty risk can be mitigated to some extent, it is something which traders should be aware of and is one example of why you shouldn’t trade with money you can’t afford to lose.