What is credit risk in securities trading?

Credit risk in securities trading specifically refers to the possibility that a counterparty—such as a borrower or another trader—may fail to fulfill their obligations as per the terms of a financial agreement. This can take the form of not making scheduled payments on a loan or not delivering securities as promised in a trade. Understanding credit risk is vital since it can lead to financial losses for the lender or the party expecting the trade to be executed.

In the context of trading, managing credit risk involves assessing the creditworthiness of the counterparties before engaging in transactions, as inadequate assessment may lead to significant risks in a trader's portfolio. This concept is particularly important in over-the-counter (OTC) trading, where transactions are conducted directly between parties and are not secured by a centralized exchange.