What is Counterparty Risk?

In finance, counterparty risk is a measurement of the probability that another party involved in a contract will default on their obligations. There are a variety of different forms of counterparty risk involved in financial contracts. Bitcoin effectively solves counterparty risk but other parts of the cryptocurrency business, like exchanges, are exposed to counterparty risk.

An Example of Counterparty Risk

When a bank makes a loan to one of their customers, the bank is taking on counterparty risk. After all, there is a risk that their customer may be unable to pay back the loan. This also works in the opposite direction. When a customer at a bank makes a deposit, they take on counterparty risk in that the bank could go bankrupt and lose the customer’s money (although things like FDIC insurance are intended to limit this risk).

Forms of counterparty risk also exist when investing in assets like corporate bonds and other forms of bonds. The returns associated with a bond are generally a measurement of the risk associated with that bond. More risk leads to potentially more reward via a higher risk premium.

Major Historical Events Involving Counterparty Risk

Defaults due to miscalculations of counterparty risk are rather prevalent throughout financial history. Let’s take a look at two examples.

Bankruptcy of Lehman Brothers in the Great Recession

The key catalyst in The Great Recession was a mismanagement of the potential risks associated with collateralized debt obligations (CDOs). In short, mortgages carrying varying levels of risk were securitized into CDOs that were given high ratings by various rating agencies. This created a mismatch between the underlying assets and the level of counterparty risk that was thought to be associated with those assets. Banks were highly exposed to these CDOs, so when mortgage borrowers began to default, the banks were left on the hook for the losses. This led to a severe collapse of the overall economy.

In 1944, the Bretton Woods Conference set the stage for the U.S. dollar to become the major reserve currency in the world. During the conference, the United State promised to always allow other countries redeem an ounce of gold in exchange for $35. Over the next couple of decades, the United States created many more dollars than they had gold. If every country had come to the United States in an attempt to redeem their dollars for gold at the same time, the U.S. would not have been able to provide each country with the proper amount of gold at the $35 per ounce peg. This is why, in 1971, U.S. President Richard Nixon closed the gold window and no longer allowed countries to trade their dollars for gold at the previously agreed upon rate. The counterparty risk that existed in the Bretton Woods System was that the United States would not honour their part of the agreement (always allowing the redemption of an ounce of gold in exchange for $35), and the United States eventually defaulted on their obligations.

Bitcoin as a Solution to Counterparty Risk

Bitcoin was created as a solution to a number of problems involving counterparty risk in digital money.

Commerce on the Internet has come to rely almost exclusively on financial institutions serving as trusted third parties to process electronic payments,” reads the original Bitcoin white paper. “While the system works well enough for most transactions, it still suffers from the inherent weaknesses of the trust based model.

Before Bitcoin, a true form of digital cash did not exist. The only thing that was possible was to store IOUs for dollars or other fiat currencies with a third party financial institution. This third party was a target for regulators around the world, and at any point in time, an individual or entity’s money held with these third parties could be seized or blocked from being sent to specific payment destinations.

With Bitcoin, the idea is that there is no counterparty risk involved in the digital monetary system. When users store Bitcoin in their own wallets at the base network layer, there is no third party who can seize the user’s Bitcoin or censor their transactions.

Counterparty Risk Still Exists in Cryptocurrency

It did not take long for various forms of counterparty risk to creep their way back into the Bitcoin ecosystem, with the most obvious example being the centralized exchanges that allow users to gain access to Bitcoin in the first place. When Bitcoin users hand their Bitcoin over to a custodian-like an exchange, counterparty risk is reintroduced into the system. Some examples of such risks are getting hacked, loss of users’ Bitcoin, or being faced with other issues that would lead the Exchange to default on their obligation to hand over their users’ Bitcoin on request.

There have been many examples of Bitcoin exchange collapses over the years, with Mt. Gox being the most prominent example.

More recently, improvements have been made in terms of limiting the counterparty risk associated with exchanges. Smart contracts like those found in the Lightning Network and the Arwen Protocol can be used to limit users’ exposure to counterparty risk while trading on exchanges. These sorts of solutions effectively make the exchanges non-custodial. There are also decentralized exchanges, that solve the problem of a central point of failure. One such solution is called Bisq, a decentralized exchange.

It could be noted that some people make the argument that miners are also a source of counterparty risk to the users of Bitcoin, which is partly true. Miners do have the ability to censor payments or reorder the transaction history; however, the Bitcoin system is set up in a manner that incentivizes miners not to act in this way. Miners attacking Bitcoin would effectively be a situation where they are attacking their own source of revenue.

As a final note on counterparty risk in Bitcoin, it’s interesting to point out that there have been instances where the cryptocurrency has increased counterparty risk for institutions in the traditional financial system. For example, credit card issuers clamped down on purchases of Bitcoin and other crypto assets via credit cards in 2017 due to the perception that there was simply too much counterparty risk involved with allowing borrowers to purchase Bitcoin directly with a credit card.

Counterparty Risk in Smart Contracts and DeFi

As mentioned above, more advanced smart contracts are in the process of removing some of the key points in the Bitcoin ecosystem where counterparty risk still exists. There have been a variety of platforms focused on these sorts of smart contracts over the years, with one of them even being called “Counterparty”.

These sorts of alternative cryptocurrency networks are focused on replacing more functions of the traditional financial system with decentralized alternatives. This is known as the decentralized finance (DeFi) movement.

While some DeFi systems, such as Bitcoin’s Lightning Network and various decentralized exchanges, are able to bring improvements that help limit counterparty risk, there are some DeFi applications, namely ones that rely on the use of an oracle, that bring the sort of counterparty risk found in the traditional financial system back into the cryptocurrency world.

Examples of DeFi applications that rely on the use of oracles include stablecoins and decentralized betting protocols. The main problem with these applications is that cryptocurrency networks have no knowledge of the outside world, so if someone wants to create a smart contract that pegs some Bitcoin or Ether to a stable asset like the U.S. dollar, then the blockchain is going to need some way to access that data. This is where the oracle comes into play.

Oracles are used to let the blockchain know about things like the current BTC/USD exchange rate, the outcome of the most recent U.S. presidential election, and who won last night’s NBA basketball game. Obviously, this oracle could be corrupted or hacked, leading to the wrong information being added to the blockchain. While there have been many attempts to decentralize the counterparty risks associated with oracles, it’s unclear if a solution will emerge that will make people feel comfortable with entrusting these oracle systems with large amounts of money.

Clearly, a Bitcoin tied up in a smart contract that pegs it to a real-world asset contains more counterparty risk than a Bitcoin stored on its own in a personal wallet.