Bilateral Contract

What Is a Bilateral Contract?

A bilateral contract is an agreement in which two parties each make binding promises to one another. Both sides give something and both are obligated to perform. In general contract law, this is the usual meaning of "bilateral," and it contrasts with a unilateral contract, where only one party makes a promise and it is accepted by performing an act.

In finance, the term most often describes a privately negotiated agreement made directly between two counterparties rather than through a public exchange. These deals are common in over-the-counter market trading, in long-term energy supply arrangements, and in many business loans. Because the two parties set the terms, the agreement can be tailored to their needs for size, timing, pricing, and settlement.

How It Works

No central body stands between the parties, so each side depends on the other to pay or deliver as agreed. This exposure is called counterparty risk. Parties often manage it with collateral, which is assets pledged to secure the obligation, and with netting, which combines amounts owed in both directions into a single net payment. Many derivative dealers sign a standard master agreement that sets these rules in advance, so individual trades do not need to be negotiated from scratch.

Some bilateral trades are later routed through a central counterparty after they are agreed. The clearing house then stands between the original parties, replacing each side's exposure to the other with exposure to the clearing house. Regulators in several markets have pushed certain standardized derivatives toward central clearing for this reason.

Example and Considerations

Consider two companies that agree one will buy a fixed quantity of electricity from the other each month for several years, at a price set today. The contract is not traded on an exchange. Its value to each side changes as market prices move, and each side depends on the other to keep paying or delivering.

Advantages:

• Terms can be customized to fit the parties' exact needs.
• Pricing and conditions are not limited to standard exchange listings.

Disadvantages:

• Counterparty risk remains if the other party cannot meet its obligations.
• Price transparency is typically lower than for exchange-traded products.
• Exiting early usually requires the other party's agreement.