Counterparty risk: what it is and how to deal with it

When a bank
grants a loan to one of its customers, the bank assumes counterparty risk. After all, there is a risk that their client will not be able to repay the loan. This also works in the opposite direction. When a bank client makes a deposit, they assume counterparty risk as the bank could fail and lose the client’s money (although things like FDIC insurance are meant to limit this risk).

There are also forms of counterparty risk when investing in assets such as corporate bonds and other forms of bonds. The returns associated with a bond are generally a measure of the risk associated with that bond. More risk leads to potentially more reward through a higher risk premium.

Bitcoin as a solution to counterparty risk

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

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

Before Bitcoin, there was no real form of digital money. 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 time, an individual’s or entity’s money held at 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 Bitcoins in their wallets at the basic network level, there is no third party that can seize the user’s Bitcoins or censor their transactions.

Main historical events involving counterparty risk

Defaults due to miscalculations of counterparty risk are quite widespread throughout financial history. Let’s look at two examples.

The key catalyst for the Great Recession was mismanagement of potential risks associated with collateralized debt bonds (CDOs). In short, mortgages carrying different levels of risk have been securitized into CDOs that have received high ratings from various rating agencies. This created a discrepancy 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 started defaulting, banks were left in trouble for losses. This led to a serious collapse of the overall economy.

In 1944, the Bretton Woods Conference laid the groundwork for the US dollar to become the world’s main reserve currency. During the conference, the United States promised to always allow other countries to redeem an ounce of gold in exchange for $35. Over the next two decades, the United States created far more dollars than it had in gold. If each country had come to the United States in an attempt to redeem its dollars for gold at the same time, the United States would not have been able to provide each country with the right amount of gold at the peg of $35 per ounce. This is why, in 1971, US President Richard Nixon closed the gold window and no longer allowed countries to exchange their dollars for gold at the previously agreed rate. The counterparty risk that existed in the Bretton Woods system was that the US would not honour its part of the agreement (always allowing the reimbursement of an ounce of gold in exchange for $35), and the US would ultimately fail to meet its obligations.

Counterparty risk still exists in cryptocurrency

It didn’t take long for various forms of counterparty risk to creep into the Bitcoin ecosystem, with the most obvious example being centralized exchanges allowing users to access Bitcoin in the first place. When Bitcoin users hand over their Bitcoins to a custodian-like exchange, counterparty risk is reintroduced into the system. Some examples of such risks are hacking, losing users’ Bitcoins, or facing other issues that would lead the exchange to fail to comply with their obligation to hand over their users’ Bitcoins upon 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 counterparty risk associated with exchanges. Smart contracts such as those found in the Lightning Network and the Arwen protocol can be used to limit users’ exposure to counterparty risk when trading on the stock exchange. This type of solution effectively makes exchanges unguarded. There are also decentralized exchanges, which solve the problem of a central point of error. One such solution is called Bisq, a decentralized exchange.

You might notice that some people argue that miners are also a source of counterparty risk for Bitcoin users, which is partly true. Miners have the option to censor payments or reorder transaction history; however, the Bitcoin system is set up to incentivize 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 is interesting to note that there have been cases where cryptocurrency has increased counterparty risk for institutions in the traditional financial system. For example, credit card issuers blocked purchases of Bitcoin and other crypto assets via credit cards in 2017 due to the perception that there was simply too much counterparty risk in allowing borrowers to buy 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 this type of smart contracts over the years, with one of them also called “Counterparty”.

These types of alternative cryptocurrency networks focus 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 make improvements that help limit counterparty risk, there are some DeFi applications, namely those that rely on the use of an oracle, that report the type of counterparty risk found in the traditional financial system in 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 hooks some Bitcoin or Ether to a stable asset like the US dollar, then the blockchain will need a way to access that data. This is where the oracle comes in.

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

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

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