An example

Suppose you buy a house. This means you swap a house for money. There’s that worrying period on the day of contract exchange when the seller’s solicitor wants your money before he will sign the sale contract, and maybe your solicitor wants your money so that he can release it on signing at the request of the seller’s solicitor. During that period - from the time you release your money to the time you have a safely legal contract of ownership - you have counterparty risk. The intermediaries - solicitors and banks in this case - are the counterparties. The seller is also a potential counterparty, if he is manipulating his solicitor in some way.

More generally……

All financial transactions involve transferring money between parties (or promises to do so). The party giving money (the ‘investor’) does so in return for a set of promises or assumptions about money coming back in the future (from the ‘recipient’). The recipient is the ‘counterparty’ to the investor. All intermediaries in the transaction are counterparties also. The risk that these promises may be broken is ‘counterparty risk’.

Types

Standard financial transactions are usually backed by rules of law and practice that give a country’s support to the recipient’s promises – in effect government guarantees to reduce counterparty risk. The strength of these guarantees, and therefore the magnitude of the counterparty risk, depends on the strength and alignment of the country offering them. You may call this Country Risk.

Counterparty risk often features in offers of investments that seem too good to be true. Such offers are by their nature questionable and you should never take them.

A standard technique is for a counterparty to take on risks in the transaction chain, receive a premium in exchange for the extra risk taken on, conceal the risks when passing it to the investor, but not passing on any of the premium.

Delivering (for a short while) on impossible promises may be achieved by a using the contributions of new investors to pay an enhanced return to existing investors. This is called a Ponzi Scheme. Famous schemes were the asset management business of Bernie Madoff in the US and the London and Capital Finance (LCF) scheme in the UK.