What is the difference between a broker and a counterparty

Anything in excess might fall in the general creditor line. If a prime broker insolvency is ever encountered, SIPC will try to distribute securities back to the clients if they can. Also during a bankruptcy distribution, assets are not marked to market. They are paid out based on the asset value on the date of bankruptcy or the filing date - this may lead to mark-to-market risk for clients. During a bankruptcy proceeding, the SIPC trustee has 2 options: 1 Sell the accounts to another broker dealer which could take up to 3 weeks.

This should create little interruption to client accounts. This process may take up to 3 months or longer. However, there are items to consider here such as the total dollar amount of the excess coverage, per customer limit or the aggregate limit.

Protection through CAPCO generally has no aggregate capital limit, while protection through a private insurer may have an aggregate limit. Note that if the prime broker is a foreign bank, then they may not necessarily carry excess SIPC since they would normally leave minimal balances at the US broker dealer entity.

SIPC does cover registered securities such as stocks and bonds. SIPC does not cover unregistered contracts such as forwards or swaps. This is because these types of contracts are not executed with the prime broker entity and are covered under an ISDA agreement. Note that it is unclear whether or not repos are covered under SIPC.

Lastly on excess SIPC, the source of the policy may also be a concern, depending on the credit status of the insurer. Whilst the provisions in the US are prescriptive and transparent the scenario outside the US is different. Where the contracting parties are UK entities, the safeguards are:. Many realise the importance of maintaining the integrity of the financial systems, which explains why the Fed is doing its utmost to facilitate funding and why countries may still bail out their homegrown institutions.

Sovereign funds, private equity funds and other cashed up investors may recognize this more than most and are buying stakes in troubled financial institutions.

This has boosted confidence in the larger players in the PB arena regardless of whether they are banks affected by the subprime crisis or broker dealers in the US. Marginal players will suffer as uncertainty persists over their financial standing. Here, we will use CDS intermediation to illustrate the mechanics. First, the hedge fund will enter an intermediation contract with the CDS prime broker.

Both the CDS prime broker and the hedge fund should have a list of approved counterparties but ultimately, the hedge fund will only be able to give-up CDS trades if done with an approved counterparty of the CDS prime broker.

At the time of a new CDS transaction, the hedge fund will inform both the counterparty and the CDS prime broker of the give-up. Once the give-up is done, the CDS prime broker now legally takes on the trade and associated risks and the hedge fund now faces the CDS prime broker, not the original counterparty. For this service, the hedge fund pays a spread and some clearing fees to the CDS prime broker. Investors should be aware of a certain risks. This margin is at risk in the case of bankruptcy.

While these are the risks on any type of counterparty trade, we should highlight that these risks are now amplified through counterparty concentration. We should note that there are certain efficiencies gained in this arrangement. Note that there is currently a discussion in the market about the creation of a CDS clearing house such that some of this issue could disappear.

This is probably a few years away. Spreads for term funding and uncollateralized borrowing have risen significantly for many financial institutions.

However, the market for short term collateralised borrowing has remained more orderly. It was extremely important that this was the case which is why the Federal Reserve opened the discount window to broker dealers and became more flexible on collateral accepted. Therefore, the major money centre banks have still been providing collateralized funding at relatively tight spreads to the PBs.

This has had the effect of mitigating the passing on of higher borrowing cost to the hedge funds. However, should a hedge fund wish to be exempted from re-hypothecation, the chain of collateral financing breaks down and significantly higher costs would need to be passed on to the fund, or the PB may not wish to have their business. Therefore, the treasury unit of the PB will monitor closely assets available for re-hypothecation to ensure they can cover the funding needs of their PB portfolio.

The situation has also been alleviated short term by the de-risking of hedge fund portfolios and the relatively high cash levels. It is likely that this risk remains low until hedge funds feel that sufficient stability has returned to PB financing before leveraging up again. While there is reasonable framework to protect hedge fund assets, it is clear that the more a hedge fund borrows, the more it becomes exposed to counterparty risk.

This may be in the form of more assets being re-hypothecated or more margins paid under an ISDA or Repo agreement. Therefore, funds with more sophisticated financing needs are more inclined to spread the risk over many PBs. Stability in hedge fund financing has been maintained to some degree as the collateralized funding market has continued to function between financial institutions.

What has changed is the reluctance for financing any illiquid assets as they prove more difficult to on finance.

Haircuts have increased especially for CDOs and emerging market bonds and other instruments. Ultimately, the hedge funds can not get away from the risks systemic to the financial system. A market maker generally stands in an Exchange, a place where everyone trades against everyone.

Stocks, options and some bond and FX trades on exchanges. Today high-frequency traders dominate the MM business. One more difference, to conclude, is that the success of a dealer mainly depends on good personal relation between clients and other dealers, whereas that of a MM depends on its technology and research team.

Connect with social network:. Skip to content. For example, if a buyer purchases a retail product online to be shipped to their home, the buyer and retailer are counterparties, as are the buyer and the delivery service.

In a general sense, any time one party supplies funds, or items of value, in exchange for something from a second party, counterparties exist. Counterparties reflect the dual-sided nature of transactions. In dealings with a counterparty, there is an innate risk that one of the people or entities involved will not fulfill their obligation. This is especially true for over-the-counter OTC transactions. Examples of this include the risk that a vendor will not provide a good or service after the payment is processed, or that a buyer will not pay an obligation if the goods are provided first.

It can also include the risk that one party will back out of the deal prior to the transaction occurring but after an initial agreement is reached. For structured markets, such as the stock or futures markets, financial counterparty risk is mitigated by the clearing houses and exchanges.

When you buy a stock, you don't need to worry about the financial viability of the person on the other side of the transaction. The clearing house or exchange steps up as the counterparty, guaranteeing the stocks you bought or the funds you expect from a sale. Counterparty risk gained greater visibility in the wake of the global financial crisis.

When AIG could not post additional collateral and was required to provide funds to counterparties in the face of deteriorating reference obligations , the U. For more on this topic risk, see our Introduction to Conunterparty Risk. Career Advice. Trading Instruments. Your Privacy Rights. To change or withdraw your consent choices for Investopedia. At any time, you can update your settings through the "EU Privacy" link at the bottom of any page.

These choices will be signaled globally to our partners and will not affect browsing data. We and our partners process data to: Actively scan device characteristics for identification. I Accept Show Purposes. Your Money. Personal Finance. Your Practice. Popular Courses. What is a Counterparty? Key Takeaways A counterparty is simply the other side of a trade - a buyer is the counterparty to a seller.