Counterparty risk is the risk that the other party to a transaction will fail to perform their obligations. In commodity trading, this can mean buyers who don’t pay, sellers who don’t deliver, or banks that fail to honor guarantees.
Types of Counterparty Exposure
Exposure Categories
Phase Exposure Type Risk Pre-delivery Replacement cost Seller defaults, must buy elsewhere Delivery Full cargo value Goods delivered, not paid Post-payment Settlement Payment made, goods not received Financial Derivative MTM Hedge counterparty defaults
Exposure Calculation
COUNTERPARTY EXPOSURE CALCULATION
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PRE-DELIVERY (Seller exposure):
Mark-to-market gain: $5M (price rose)
Current exposure: $5M (the MTM gain we'd lose)
POST-DELIVERY (Buyer exposure):
Payment status: Outstanding
MTM value: +$3M (in our favor)
TOTAL EXPOSURE TO COUNTERPARTY X:
$5M + $100M + $3M = $108M
Credit Assessment
Assessment Framework
CREDIT ASSESSMENT PROCESS
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- Income statement trends
2. QUALITATIVE ASSESSMENT
- S&P, Moody's, Fitch (if rated)
- Internal rating assigned
Key Ratios
Ratio Formula Healthy Range Current ratio Current assets / Current liab >1.5 Quick ratio (CA - Inventory) / CL >1.0 Debt/Equity Total debt / Equity <2.0 Interest coverage EBIT / Interest expense >3.0 Days payable AP × 365 / Purchases <60
Credit Scoring
Financial Strength (40%):
- Track record with us: 10%
A: Excellent (80-100 points)
E: High risk (<20) - Decline
Company X scores 68 → Rating B
→ Terms: L/C or 30-day open account
Credit Limits
Limit Structure
Rating Max Exposure Terms
B $50M 30-day open or L/C
D $5M L/C sight, confirmed
L/C at sight: Issuing bank risk only
Confirmed L/C: Confirming bank risk
Prepayment: No credit risk
Limit Monitoring
Counterparty Rating Exposure Limit %Used
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Refiner A A $85M $100M 85%
Trading Co B B $48M $50M 96% ⚠️
Utility C A $62M $100M 62%
Producer D B $38M $50M 76%
Smelter E C $18M $20M 90% ⚠️
⚠️ Trading Co B: 96% utilization
Action: Review before new trades
⚠️ Smelter E: 90% utilization
Action: Request L/C for next trade
Top 5 counterparties: 45% of total exposure
Risk Mitigation
Security Instruments
Instrument Protection Level Cost L/C at sight High (bank guarantee) 0.2-0.5% Confirmed L/C Very high (2 banks) 0.5-1.5% Credit insurance High (85-95% recovery) 0.3-1.0% Parent guarantee Depends on parent Negotiated Prepayment Full protection Interest cost Retention of title Legal protection None
Credit Insurance
Insurer: Euler Hermes / Coface / Atradius
Coverage: 90% of invoice value
Premium: 0.5% of insured sales
Deductible: 10% (our retention)
1. Request credit limit from insurer
2. Insurer assesses buyer
3. Limit granted (or declined)
4. Ship goods, report shipments
5. If default → file claim
6. Receive 90% after waiting period
Recovery from insurance: $9M (90%)
Netting Arrangements
We owe them: $30M (receivable for cargo)
They owe us: $50M (payable for cargo)
Net exposure: $50M - $30M = $20M
Without netting: We lose $50M, still owe $30M
With netting: We lose $20M net
Master netting agreement in place
Enforceable under bankruptcy law
Watchlist and Deterioration
Early Warning Signs
Signal Description Action Payment delays Paying late Review, reduce limits Financial deterioration Weakening ratios Reassess rating Management changes Key person leaves Due diligence News/rumor Negative press Investigate Rating downgrade External agency action Immediate review Industry stress Sector downturn Portfolio review
Watchlist Management
COUNTERPARTY: Industrial Co Y
TRIGGER: Payment delayed by 15 days
1. Called counterparty - cash flow issue cited
2. Reviewed financials - leverage increased
3. Reduced limit from $50M to $30M
4. Required L/C for next shipment
5. Weekly monitoring initiated
If payment >30 days late → Move to D rating
If payment >60 days late → Provision/write-off
Default Management
Default Response
DEFAULT RESPONSE PROTOCOL
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DAY 1-3: Immediate response
- Halt all new transactions
- Calculate total exposure
- Determine recovery prospects
- Contact insurer (if insured)
DAY 10-30: Recovery action
- Initiate insurance claim
- Monitor counterparty status
- Negotiate restructuring
Provisioning
0-30 days overdue: 0% provision
31-60 days overdue: 25% provision
61-90 days overdue: 50% provision
>90 days overdue: 100% provision
Debit: Bad debt expense $5M
Credit: Allowance for doubtful accounts $5M
If $8M eventually collected:
Credit: Bad debt recovery $3M
Key Takeaways
Know your exposure — Calculate pre-delivery and post-deliveryCredit assessment is continuous — Not just at onboardingLimits must be enforced — No exceptions without approvalMitigation has cost — Balance protection vs. expenseWatch for deterioration — Early action prevents lossesHave a default playbook — Know what to do when it happens
References
Basel Committee Credit Risk Standards
ISDA Credit Support Documentation
Trade credit insurance industry guides
Moody’s Analytics Credit Risk