What type of risk is associated with credit default swaps traded over-the-counter?

Credit default swaps (CDS) traded over-the-counter (OTC) carry significant counterparty risk. This type of risk arises from the possibility that one party in the transaction may default on their contractual obligations. Since OTC derivatives are not traded on an exchange, there is no intermediary to guarantee the performance of the contract, meaning that if one party fails to fulfill their side of the agreement—such as making the premium payments or, in the case of a default, making the necessary payments to cover the loss—the other party is left exposed to that risk.

In the context of credit default swaps, this is particularly poignant because the buyer of a CDS is relying on the seller to uphold their commitments in the event of a credit event, such as default of the underlying reference entity. If the seller defaults and cannot pay the buyer when necessary, it creates a significant financial exposure for the buyer, which is the essence of counterparty risk.

While liquidity risk, operational risk, and market risk are important considerations in financial markets, they do not capture the specific risk presented by the nature of OTC trading in CDS. Liquidity risk is more about the ease of buying or selling an asset, operational risk relates to failures in processes or systems, and market risk pertains to