What is Counterparty Risk?

Counterparty risk is the risk that the entity on the other side of a transaction fails to perform — a borrower defaults on a loan, a derivative counterparty cannot meet its mark-to-market obligations, a custodian becomes insolvent.

Where wholesale investors encounter counterparty risk:

1. Credit funds — borrower risk: the primary counterparty risk in NZ wholesale credit funds is borrower default. Fund returns depend on borrowers repaying interest and principal as scheduled. Default rates in NZ first-mortgage funds have historically run at 0.5-3% of portfolio per annum, with recovery rates typically 80-95% for senior-secured positions.

2. Custodian risk: fund assets are typically held by an independent custodian (Public Trust, Trustees Executors Ltd, New Zealand Guardian Trust). Custodian insolvency would expose investors if assets were not properly segregated, though NZ law requires asset segregation in normal circumstances.

3. Supervisor risk: the supervisor of a managed investment scheme is the gateway for monitoring manager compliance. A weak supervisor — one that does not enforce the trust deed or SIPO — exposes investors to manager malfeasance.

4. Derivative counterparty risk: for funds using derivatives (foreign-currency hedges, interest-rate swaps), the derivative counterparty (typically a major bank) must perform. Wholesale credit funds rarely use complex derivatives so this is a lesser risk than for institutional fixed-income managers.

5. Broker / platform risk: investors using investment platforms (Sharesies, Hatch, Snowball Effect) face platform-level operational risk separate from the underlying-investment risk. NZ platforms are generally well-regulated but operational failures have occurred.

Mitigation: - Asset segregation — required under FMCA for MIS structures; the supervisor verifies that fund assets are not commingled with manager assets. - Diversification — exposure to many counterparties (e.g. many borrowers in a credit fund) reduces single-counterparty impact. - Counterparty quality — institutions use credit ratings, capital adequacy ratios, and reputational track record to select counterparties. - Independent oversight — supervisors, auditors, and AML/CFT supervisors provide third-party assurance.

Wholesale Investor NZ context: every provider profile links to the manager's FSPR registration and (where applicable) NZBN, providing primary-source verification of regulatory status. Counterparty-risk assessment ultimately requires investor diligence on the specific fund and its underlying-portfolio counterparties.